October Bottom Up IERP & A-Series Backtest Result

October 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 October 2, our bottom up methodology yields an IERP estimate of 3.19 percent. This reflects a material decline from the 3.79 percent estimate reported in July. 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:

October Bottom Up IERP & Model Values.xlsx

Download XLSX • 381KB

A-Series Model Backtest

When we calculate our bottom-up implied equity risk premium estimates, we rely upon the semi-discretionary valuation models developed and employed at Baoro Research. These models permit the exercise of judgment in two principal respects. First, discretion is used in the selection of the relevant cash flows that form the basis of the valuation. Second, discretion is used in determining the appropriate beta inputs that are applied within the valuation framework. By adopting this bottom-up approach, we are able to continually assess and refine the effectiveness of our models through comparison to their historical trading results.

The historical testing process incorporates a lookback period that extends from the date of a security’s initial public offering through the present. This enables us to develop a comprehensive view of how the models interpret valuation conditions across time and how the market price of a security compares to its estimated intrinsic value. The trading framework is entirely rule based and is triggered by the divergence between market price and intrinsic value. A buy signal is generated when the model concludes that the security is priced at a level expected to produce an annualized alpha of at least five percent. For purposes of this calculation, alpha is measured relative to the company’s cost of equity or required rate of return as determined under the capital asset pricing model. A sell signal is generated when the implied equity risk premium for a security becomes sufficiently low. In practice, this typically occurs when the implied equity risk premium for the security rises above two standard deviations of the market’s implied equity risk premium.

We maintain records of all historical trades generated by the models and subject those trades to further analysis. The measures reviewed include total number of trades, overall profitability, average return in instances of favorable outcomes, average return in instances of unfavorable outcomes, the standard deviation of returns in both categories, and average historical holding periods. The following table sets forth the most current model values, calculated against the top eighty percent of the constituents of the S&P 500 as of today.