Driving increases in shareholder value is one of the most important responsibilities of any business leader, but many are handicapped by not having a deep understanding of what drives value. Factors that drive value are easily understood using a simple constant growth equation: P = E / (C – G). When combined with a new approach for estimating the Market Risk Premium, called the Risk Premium Factor, current risk free rate and some simplifying assumptions, the Risk Premium Factor Model explains S&P Index levels with good accuracy for 1960 - present.
The RPF valuation model is P = E / ((Rf x (1+RPF) – (Rf - IntR+ GR)), where
Rf = 10 Year Treasury yield
E = S&P 500 operating earnings
IntR = Long-term real interest rates derived from TIPS yields
GR = Long-term real growth rate for the Earnings assumed to be long-term GDP growth
RPF = Risk Premium Factor Constant
Results for 1960 – 2008 are shown below:
This tells that only three things matter:
- Earnings
- Growth
- Interest rates which drive cost of capital and embody inflation.
For more on underlying assumptions behind the calculations please see "The Risk Premium Factor: A New Model for Understanding the Volatile forces that Drive Stock Prices" (Wiley Finance) available on Amazon. (http://amzn.to/jRHEAe )
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