Key Takeaways

  • We use a residual income model to compute an intrinsic value for the market. This model considers forecasts for future earnings and for long-term earnings growth to estimate the equity risk premium for the S&P 500.
  • We combine the equity risk premium with the risk-free rate to produce an equity yield, and compare the equity yield to the yield on investment grade bonds to classify the market as undervalued, overvalued or fairly-valued.
  • When the equity market is overvalued relative to investment grade bonds, it tends to see smaller returns and higher volatility. Currently, we consider the market to be undervalued.

Market Valuation, Equity Yields and the Residual Income Model

Many quantitative metrics have been put forth to evaluate the valuation level of the market, i.e. whether it is “cheap” or “expensive.” The forward price-to-earnings ratio is one example of such a metric. In this note, we introduce a unique and differentiated method for computing the level of market valuation.

Our method makes use of a residual income model to estimate the equity risk premium. The residual income model works like a dividend discount model or discounted cash flow model in that it computes the current value of an asset (in this case, the S&P 500...

Unlock this article with a FREE 30-Day Trial!

An FSI Pro, or FSI Macro subscription is required in order to access this content.

*Free trial available only on a monthly plan

Disclosures (show)

Get invaluable analysis of the market and stocks. Cancel at any time. Start Free Trial

Articles Read 2/2

🎁 Unlock 1 extra article by joining our Community!

You’ve reached your limit of 2 free monthly articles. Please enter your email to unlock 1 more articles.

Already have an account? Sign In

Don't Miss Out
First Month Free