Question

On April 9th 2020, the S&P500 was trading at 2,750, implying a current P/E ratio of 18. The expected cash payout ratio (dividends + buybacks) is 92% of earnings (in perpetuity). Analysts’ consensus annual growth forecast in earnings for the index is 3.5% for the next 5 years. Use a risk free rate of 0.8% and set the long term growth rate equal to the risk free rate. 1) Estimate the implied equity risk premium using a two-stage growth model given the current level of the S&P500 index and expectations of cash flows. 2) All else equal (i.e. for a given level of the S&P500 index), what would happen to the iERP if the COVID crisis led investors to lower substantially their expectations of dividends and buybacks? (Would it go up or down?)

Answer 1

1). S&P index value = 2,750; implied PE = 18, so Earnings = Index value/PE ratio = 2,750/18 = 152.78

Cash payout ratio = 92% of earnings so,

current cash flow = 92%*152.78 = 140.56

Using the given values and applying the two-stage model, we have:

The discount rate is arrived at using Excel Solver, as follows:

The return rate on the index is 6.60% so equity risk premium is return on index - risk-free rate = 6.60% -0.8% = 5.80%

2). If expectations of dividends and buybacks decreases, the equity risk premium will decrease as well, since associated risk is decreasing.