November Bottom Up

November Bottom Up IERP

The Implied Equity Risk Premium (“IERP”) is commonly estimated using methodologies similar to the internal rate of return in project finance or the yield to maturity of a fixed income instrument. At the aggregate market level, the IERP is understood as a market capitalization weighted average of the IERPs of the individual securities that comprise the index. This framework permits the cross validation of top down IERP estimates by reference to bottom up calculations performed at the security level.

Our bottom up estimation process, conducted on a monthly basis, entails valuing individual securities using cash flow measures deemed appropriate under the circumstances, which may consist of dividends only, dividends together with share repurchases, or free cash flow to equity. Long term median regression betas are employed as the primary measure of systematic risk. It should be noted that these estimates do not incorporate adjustments for country risk premiums or for other categories of risk premium, including small capitalization risk premiums.

In light of the limited incremental benefit associated with valuing all 500 plus constituents of the S&P 500 Index, we calculate IERPs directly for those securities that, in the aggregate, represent 81.60 percent of the index’s total market capitalization, equivalent to 138 of the 503 constituents. The implied premiums for the remaining securities are extrapolated by reference to the median IERP derived from the directly calculated sample.

As of November 6, our bottom up methodology yields an IERP estimate of 3.056 percent. This reflects a decline from the 3.19 percent estimate reported in October. Such a decrease indicates that investors are presently requiring a reduced premium over the risk free rate to hold equities, a condition that may reasonably be interpreted as evidence of elevated equity valuations relative to fixed income securities.

Detailed security specific IERP estimates and model valuation output can be found in the attached file below:

November Bottom Up IERP.xlsx

Download XLSX • 379KB