Jul 1, 2013

"S&P 500 Intrinsic Value Calculator"

While the technical analysis of various indexes and ETFs can reveal overbought and oversold conditions, keeping an eye on the intrinsic valuation of the equity market can be like a compass to navigate the Investment hike.

The details of the valuation calculator is at the bottom of this post if you want those details first, but lets begin with the calculator itself. Before I could get started with any calculation, I saw that Prof. Aswath Damodaran has already been publishing the S&P 500 Intrinsic valuation blog post for the past 2 years. So what additional value could I have added? I noticed that his valuation calculator is for a point in time - year beginning. So I just migrated this to Google excel sheets and made it pull the latest price for S&P 500 and the 10 year yield. Here is the Intrinsic value for S&P 500:
(For some reason, Google Docs is not showing the 2nd sheet in the same spreadsheet. So click on SP500 valuation tab in the sheet below)

I agree that some of the inputs are not updated everyday, like - Cash yield (dividend and buy back yield), growth rate expectations and Equity risk premium. But we may not want these inputs to be changing daily - may be just quarterly or annually.

Now that valuation was based on me choosing the input to the calculator based on my judgement. But what if we would also like to Scenario analysis for S&P 500. So I varied the inputs in such a way that the calculator gives the Maximum and the Minimum values separately. Below table shows the range for the S&P 500 Intrinsic value based on different scenario inputs.

Now that we have already seen the intrinsic values, let get down to the nuts and bolts of the calculator itself. There are 4 variables the go into the calculation:
Cash returned to equity investors: Ultimately, we buy stocks to get cash flows in return, with those cash flows evolving over the last three decades from almost entirely dividends to a mix of dividends and stock buybacks. Holding all else constant, the more cash that is returned to investors in the near term, the more you will be willing to pay for stocks.
Expected growth: The bonus of investing in equity, as opposed to fixed income, is that you get to share in the growth that occurs in earnings and cash flows in future periods. Other things held equal, the higher the expected growth in earnings and expected cash flows, the higher stock prices should be. 
Risk free rate: The risk free rate operates as more than base from which you build expected returns as investors. It also represents what you would earn from investing in a guaranteed (or at least as close as you can get to guaranteed) investment instead of stocks. Consequently, stock prices should increase as the risk free rate decreases, if you hold all else fixed. 
Risk premium: Equities are risky and investors will demand a “premium” for investing in stocks. This premium will be shaped by investor perceptions of the macro economic risk that they face from investing in stocks. If the equity risk premium is the receptacle for all of the fears and hopes that equity investors have about the future, the lower that premium, the more they will be willing to pay for stocks. 
Please read the entire post here for the details on judging the inputs and interpreting the out of the valuation.