Much as I would love to claim that I have the estimated the equity risk premium to the second decimal point, the truth is that there is some give in these numbers and that changing assumptions about earnings and cash flows generates an equity risk premium between 4-5%. The contrast between the behavior f equity risk premiums in 2020 and 2021 are in the picture below, where I show my (daily) estimates of ERP during 2020 on the left, and my (monthly) estimates of ERP for 2021 on the right. I have computed the implied equity risk premium at the start of every month, since September 2008, and during crisis periods, I compute it every day. To understand the intuition behind the implied equity risk premium, it is easiest to start with the concept of a yield to maturity on a bond, computed as the discount rate that makes the present value of the cash flows on the bond (coupons, during the bond’s lifetime, and face value, at maturity) equal to the price of the bond. During 2020, the equity risk started the year at about 4.7%, spiraled to almost 8% on March 23, 2020, before reverting back quickly to pre-crisis levels by September 2020. During 2021, you saw equity risk premiums revert back to a more sedate path, with numbers staying between 4% and 5% through the course of the entire year.
In the last three years, SPACs (special purpose acquisition companies) have given traditional IPOs a run for their money, and in this post, I look at whether they offer a better way to go public or are more of a stop on the road to a better way to go public. For decades, the process that companies in the United States have used to go public has followed a familiar script. Whatever the reasons for the Chinese government’s actions, it is undeniable that they have changed the calculus, at least for the moment, of how the Chinese government affects Chinese tech company valuations. First, the Chinese government can not only change the competitive balance and business more decisively than democratic counterparts, where making laws involves trade offs and bargains, but also make the changes more permanent, since a change in government is not in the cards. You can ban or restrict buybacks, but that will not make investment projects more lucrative and earnings more predictable, and it certainly is not going to create a new industrial age. However, it was Ben Graham, a young associate of Baruch, who laid the foundations for modern value investing, by formalizing his approach to buying stocks and investing in 1934 in Security Analysis, a book that reflected his definition of an investment as “one which thorough analysis, promises safety of principal and adequate return”.
To see this approach play out, at least in the early days of value investing, take a look at these screens for good stocks that Ben Graham listed out in 1939 in his classic book on the intelligent investor. That is not to suggest that there were not investors who were ahead of the game, and the first stories about value investing come out of the damage of the Great Depression, where a few investors like Bernard Baruch found a way to preserve and even grow their wealth. Nothing good can last-and in the case of carbon-14, a radioactive isotope found in Earth’s atmosphere, that’s great news for archaeologists. Those criteria are found by poring over the data and looking at historical returns, a path made more accessible by access to huge databases and powerful statistical tools. On the risk free rate, I start with 1.51%, the 10-year treasury bond rate on January 1, 2022, but I will assume that this rate will drift upwards over the next five years to reach 2.5%. That reflects my view that inflation pressures will push up long term rates in the year to come and has little to do with what the Fed may or may not do with the Fed funds rate.
In the last decade or two, we have seen the rise of titled index funds and ETFs, where you start with an index fund or ETF, and tilt the fund/ETF by overweighting value stocks (high PE/PBV, for instance) and underweighting non-value stocks. In computing this implied equity risk premium for the S&P 500, I start with the dividends and buybacks on the stocks in the index in the most recent year (which is known) and assume that they grow at the rate that analysts who follow the index are projecting for the next five years. As talk of a bubble fills the air, one way to reframe the question of whether stocks are in bubble territory is to ask whether the current implied equity risk premium has become “too low”. Beyond the fifth year, I make the simplifying assumption that earnings growth will שירותי ליווי converge on the nominal growth rate of the economy, which I set equal to the risk free rate. I would strongly encourage you to take my valuation spreadsheet, change the numbers that I have used on earnings, cash flows, the risk free rate and the equity risk premium to reflect your views, and come up with your own assessment of value.