tag:blogger.com,1999:blog-8152901575140311047.post3051483830834525410..comments2023-03-26T09:18:09.204-04:00Comments on Musings on Markets: An ERP Retrospective: Looking back (2014) and Looking forward (2015)Aswath Damodaranhttp://www.blogger.com/profile/12021594649672906878noreply@blogger.comBlogger26125tag:blogger.com,1999:blog-8152901575140311047.post-10428373102936946912015-10-02T10:40:53.803-04:002015-10-02T10:40:53.803-04:00Professor,
I know you include buybacks/stock issu...Professor,<br /><br />I know you include buybacks/stock issuance in your calculation for ERP. In this article, Research Affiliates (Rob Arnott's firm) concludes that: "The dilution rate for the U.S. equity market in 2014 was 1.8%, equivalent to roughly $454 billion. Companies thus issued significantly more shares than they repurchased."<br /><br />http://www.researchaffiliates.com/Our%20Ideas/Insights/Fundamentals/Pages/385_Are_Buybacks_an_Oasis_or_a_Mirage.aspx?_cldee=cGJhbnNhbEBpbnYudWNoaWNhZ28uZWR1<br /><br />Any thoughts on whether there has been net buyback or dilution over the last few years?<br /><br />Thanks,<br />PMPMhttps://www.blogger.com/profile/07815853830372902348noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-78627123429534301702015-08-27T02:53:06.895-04:002015-08-27T02:53:06.895-04:00I've spent two whole days thinking about diffe...I've spent two whole days thinking about different estimates of the ERP, and would like to do my best to try and clear up what to me seems like some confusion. Earlier you wrote:<br /><br />"Assume that you own all of the equity in the S&P 500 and that you are looking at your IRR, based on future cash flows. Both dividends and stock buybacks go to you (since you are the only owner) and they will look exactly equivalent to you."<br /><br />I don't think this is the case. Dividend estimates for an index are made on the basis that you continue to hold the shares. If you hold fewer shares as a result of a buyback you will receive less cash in the future as a result.<br /><br />Suppose the S&P 500 has a fixed annual payout per share, c, and you start with s shares. If all payouts were dividends the cash flow would be c.s + c.s + c.s + ... On the other hand if all payouts were stock buybacks the cash flow would be c.s + c.s.(1-c/p1) + c.s.(1-c/p1-c/p2) + ... Where p1, p2 are the price levels of the index at the time of the buybacks. The cash flow reduces because you hold fewer and fewer shares as time progresses. Dividends and buybacks are not equivalent.<br /><br />To compute the value of equity for an index one needs to at least notionally continue to hold the shares in the index. This means you don't get to participate in the buybacks. In short I don't think share buybacks and share issues have any effect on the calculation of the ERP based on an index. Computing the ERP using total market cap and dividends is a different story, and there the dilutive effect of such issues would need to be considered.<br />Anonymoushttps://www.blogger.com/profile/03257314899062008520noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-78510734640044787512015-06-23T14:13:57.447-04:002015-06-23T14:13:57.447-04:00Professor,
No answer on that?
"In this post...Professor,<br /><br />No answer on that?<br /><br />"In this post (http://aswathdamodaran.blogspot.com.br/2014/09/stock-buybacks-they-are-big-they-are.html) you considered not only dividends and buybacks in order to estimate cash returned to shareholders, but also shares issued by companies. Why haven´t you considered this in your calculations of ERP?"<br /><br />best regards,Anonymoushttps://www.blogger.com/profile/00733295098225656754noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-72496811047918451332015-06-03T16:14:00.288-04:002015-06-03T16:14:00.288-04:00Professor,
In this post (http://aswathdamodaran.b...Professor,<br /><br />In this post (http://aswathdamodaran.blogspot.com.br/2014/09/stock-buybacks-they-are-big-they-are.html) you considered not only dividends and buybacks in order to estimate cash returned to shareholders, but also shares issued by companies. Why haven´t you considered this in your calculations of ERP?<br />Anonymoushttps://www.blogger.com/profile/00733295098225656754noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-86772067934264756842015-02-16T16:16:34.653-05:002015-02-16T16:16:34.653-05:00Professor Damadoran,
First, thank you for this gr...Professor Damadoran,<br /><br />First, thank you for this great post and for all your prior research on ERP. <br /><br />I have a simple question: after reviewing this post, last year's version of it, and "Equity Risk Premiums (ERP): Determinants, Estimation and Implications" at SSRN, I cannot figure out why you assume that S&P earnings growth in the second stage of the model should be equal to the risk-free rate (however defined).<br /><br />It would seem to me that estimating second-stage earnings growth as the risk-free rate would work for an individual company subject to competition better than for a (proxy for) the economy as a whole. For the S&P 500, companies compete with one another, the winners win, new entrants come in with high margins, etc.<br /><br />Can you elaborate on why the best assumption for second-stage earnings growth is the risk-free rate (I understand and agree that the 10-year Treasury is the best proxy for the risk-free rate, but why *any* risk-free rate)?<br /><br />Thank you.ryanwhhttps://www.blogger.com/profile/13363978630336374422noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-38076173908019342972015-01-19T19:54:33.776-05:002015-01-19T19:54:33.776-05:00Michael,
If the expected return on equity stays fi...Michael,<br />If the expected return on equity stays fixed (fixed cost of equity) and earnings growth remains unchanged, the PE ratio will stay stable. And you are right. This depends on a smooth progression of rates, rather than a spike.Aswath Damodaranhttps://www.blogger.com/profile/12021594649672906878noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-12526627733988109342015-01-19T15:57:12.842-05:002015-01-19T15:57:12.842-05:00I really like that last chart which shows how tota...I really like that last chart which shows how total required return has been rather stable the past decade, while ERM increases came mostly from rate drops<br /><br />my interpretation of that chart is that ERM & rates are in a negative correlation environment, and if rates smoothly rises the next few years (controlled rise, not some crisis induced spike), then ERM will decrease. So if the world has similar growth outlooks the market P/E would be essentially the same.<br /><br />would you agree with that interpretation?<br /><br />mspacey4415https://www.blogger.com/profile/11868322471454225634noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-17262019434943999802015-01-13T00:13:54.246-05:002015-01-13T00:13:54.246-05:00Dear Professor,
Thanks for this great post!.
I ha...Dear Professor,<br /><br />Thanks for this great post!.<br />I have a fundamental question here..when an investor is looking at equity he/she is not only looking at dividend and buybacks but also capital appreciation. How is the last element getting captured in the <br />ERP.Are we agreeing that the ERP computation process has some of the shortcomings like that in dividend discount modelShishirhttps://www.blogger.com/profile/12955838139115071469noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-75902416062020217092015-01-08T21:44:19.263-05:002015-01-08T21:44:19.263-05:00Thank you for your feedback. Since you used bonds ...Thank you for your feedback. Since you used bonds as the starting point for your framework, for consistency then you should have included quantitative easing - which is like the government buying back its own bonds. My point is you are using the value of an asset (shares repurchased x price) to value that asset. It's the cash flows that such asset generates, in the case of equities future dividends, that give them a value. The fact that I can sell those shares to the company or anyone else is the outcome of that valuation, not the input. Eric T.noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-84383432156204664322015-01-08T16:07:37.206-05:002015-01-08T16:07:37.206-05:00I have never subscribed to the notion that if Buff...I have never subscribed to the notion that if Buffett says it, it must be true. You are free to make your own judgment.Aswath Damodaranhttps://www.blogger.com/profile/12021594649672906878noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-75155414000072073672015-01-08T16:05:38.759-05:002015-01-08T16:05:38.759-05:00Eric,
I have to disagree with you. Assume that you...Eric,<br />I have to disagree with you. Assume that you own all of the equity in the S&P 500 companies. Both dividends and buybacks come to you, right? Thus, you collect both as cash flows. It is true that using per share growth rates can lead to an inconsistency and that was the basis for my prior exchange with 3rd Moment, but to argue that buybacks are not cash flows to equity investors is to miss a large portion of the cash flows to equity investors collectively today.Aswath Damodaranhttps://www.blogger.com/profile/12021594649672906878noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-65920627102701806392015-01-08T08:23:36.237-05:002015-01-08T08:23:36.237-05:00"Risk premiums are mostly nonsense. The world..."Risk premiums are mostly nonsense. The world isn't calculating risk premiums." -- Warren Buffett (2005)Anonymousnoreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-80445498933388955452015-01-08T06:29:25.601-05:002015-01-08T06:29:25.601-05:00Hello. It is incorrect to include buybacks in deri...Hello. It is incorrect to include buybacks in deriving the implied equity discount rate. Just look at how the dividend discount model is calculated. And a buyback is not a dividend; it alters the number of shares outstanding, so we are mixing apples and potatoes. If you are valuing a house, you can use the rents (yield) you will get into perpetuity; it is wrong to use the proceeds of the sale of rooms to figure out that yield because we are mixing returns with the asset we are valuing. If you exclude that you will find that the implied equity risk premium is much lower than what you are suggesting - as it should be in a low interest rate environment. Thank you. <br />Eric T.noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-28190229763633755372015-01-06T16:17:51.411-05:002015-01-06T16:17:51.411-05:00Professor,
Can you explain where "r = Implie...Professor,<br /><br />Can you explain where "r = Implied Expected Return on Stocks" is derived from in your calculations? I did not see that mentioned anywhere.Bennoreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-50027498099343152912015-01-06T10:16:45.168-05:002015-01-06T10:16:45.168-05:00Hi Aswath! Been reading you for years -- fantastic...Hi Aswath! Been reading you for years -- fantastic stuff! <br /><br />I am an armchair economist, i.e. not an economist at all, but I understand a lot.<br /><br />You wrote that the following would be disastrous:"a drop in earnings and an increase in interest rates, with an overlay of a global crisis..."<br /><br />How likely do you think that will happen in the Canadian economy? I can see it happening very clearly. If the market flattens and Canada is "forced" to raise rates (the OECD has been on their butt to do that for years), and oil prices remain low, in a country as highly levered as Canada (our average level of debt is quite high because of the overheated housing market), what result do you think that would have? <br /><br />Thanks very much!<br />KZKaiserinahttps://www.blogger.com/profile/18362224370060309917noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-82869485706154775122015-01-05T17:04:19.288-05:002015-01-05T17:04:19.288-05:00Professor,
Could you explain how did you obtain t...Professor,<br /><br />Could you explain how did you obtain the long term growth rate of 5.58% on 01/01/2015?<br /><br />ThanksAnonymousnoreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-52313843534973032742015-01-05T14:46:59.786-05:002015-01-05T14:46:59.786-05:00Thanks for the discussion, and yes it appears we w...Thanks for the discussion, and yes it appears we will have to disagree.<br /><br />I'm not sure why you are so skeptical about the divisor. A few years ago I also had some questions/concerns about the index earnings calculations, but when I sat down with the methodology document I convinced myself that it appears to be very well designed. The goal would be to get an accurate measure of returns to an investor who holds a cap-weighted basket of stocks in the 500 largest firms. This basket is constantly changing as firms shrink and grow, merge and split, and as new firms appear and others go out of business completely. And of course you also need to account for stock issues and repurchases. All this stuff is covered in the methodology document in what looks to me like the correct way. <br /><br />I admit I haven't tried to get the compustat data and recreate the calculation myself...that might be an interesting exercise. My confidence in the index calculation is bolstered by the fact that realized returns to investors in S&P500 index funds closely track the numbers reported by S&P. But if you have some specific idea of how they are doing it wrong, I think a lot of people would be very interested in that.<br /><br /><br />In any case, I think we can agree that it is VERY important to be clear on what you are forecasting. If you are forecasting earnings-per-index-share, then it is double counting to include buybacks as cashflows to shareholders. Since buyback yield is over 2%, this makes a very important difference in your overall return forecast.<br /><br />Your point about not knowing what analysts are really doing is a valid one, I suppose, as is your skepticism about bottom-up forecasts. But it seems like a weak defense to me. The forecasts aggregated by S&P are labeled as "per-share", and they are measured in units that can only be interpreted as per-share, so it seems most reasonable to assume that (to the extent they have any value at all) they should be taken as forecasts of per-share earnings.<br /><br /><br />Also note that if you were to try instead to focus on collective total earnings instead of per-share earnings, you would need to account for the fact that the index is constantly changing, and the net effect is the "dilution" that I referenced in an earlier comment. So you'd need a growth rate somewhat smaller than the overall growth rate of total earnings in the economy.<br /><br /><br />The reason that this is important is that I believe that your forecast of 8% nominal returns (implying something like 6% real returns) going forward is unrealistically high, due to the double-counting issue, and also the fact that you appear to be using gross rather than net buybacks (as far as I can tell). This problem is partly ameliorated by the fact that your terminal growth rate might well be too low if you were to take it as a measure of per-share growth. If we were to instead look at earnings yields directly, and how they have historically related to real fundamental returns, I believe we would get a lower forecast.<br /><br />Thanks again, I enjoy the blog.3rdMomenthttp://3rdmoment.blogspot.com/noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-48673763315913202002015-01-04T15:53:02.070-05:002015-01-04T15:53:02.070-05:003rd Moment,
While you are right to be cautious abo...3rd Moment,<br />While you are right to be cautious about the possibility of double counting of growth, I think that you and I have to disagree on the treatment of buybacks as cash flows and here is why. Assume that you own all of the equity in the S&P 500 and that you are looking at your IRR, based on future cash flows. Both dividends and stock buybacks go to you (since you are the only owner) and they will look exactly equivalent to you. It is true, though, that if companies return the cash to you, they cannot reinvest it, and that is why the growth rate in your earnings will be lower. My fundamental growth rate is based on the much lower reinvestment that companies are making.<br /><br />On the S&P divisor, here is what I mean by fuzzy. I In 2014, buybacks were about six times larger than buybacks and if there had been no changes to the index, the divisor should have decreased by about 2-3%. The divisor barely changed. If the changes to the index explain it, then I am afraid the divisor becomes an almost meaningless number to track. <br /><br />Finally, on growth, I am constantly looking for ways to avoid double counting growth. Clearly, bottom up estimates are off the table, since they are based on per share earnings in individual companies. With aggregate earnings in the S&P 500, it is unclear what analysts are forecasting. If they are forecasting collective earnings at the existing companies in the index, then there is no problem using the estimate. If they are doing something more complex, I might be. I don't know and I don't think the analysts themselves are clear. That is why I offer the alternative of using the fundamental growth rate.Aswath Damodaranhttps://www.blogger.com/profile/12021594649672906878noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-2465797726368455732015-01-03T23:23:45.645-05:002015-01-03T23:23:45.645-05:00Should historical growth in earnings for 10-year p...Should historical growth in earnings for 10-year period be 5.42% instead of 4.14%? It looks like you have taken 9-year period growth.Anonymousnoreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-68577925324733870602015-01-03T14:10:26.570-05:002015-01-03T14:10:26.570-05:00I don't know what you mean by "units,&quo...I don't know what you mean by "units," (this concept doesn't appear in the S&P methodology document), and I don't understand what part of the methodology you think is fuzzy. <br /><br />If you are referring to the divisor, you are correct that it hasn't fallen as much as you would expect if buybacks were the only factor (and even then, you need to be careful to use net rather than gross buybacks). This is because the divisor is also adjusted for certain other things like when firms are added/dropped from the index and for mergers or spin-offs. This captures the effect of the "dilution" that Bernstein and Arnott write about here:<br />https://www.researchaffiliates.com/Production%20content%20library/FAJ-2003-Two-Percent-Dilution.pdf<br /><br />It is true that all these factors taken together have resulted in only a small decrease the divisor in recent years. But this is in contrast to some earlier periods where the divisor grew substantially.<br /><br />In any case, the divisor (and the per-share earning numbers that it is used to calculate) *entirely* reflects the benefit that share buybacks provide to shareholders. So I still don't see how you can justify using per-share forecasts AND counting buybacks as if they were dividends.<br /><br />The way I think of it, whatever earnings the firm doesn't pay out in dividends, it retains to invest to generate earnings growth. It can do this the traditional way by making real investments, or it can do share repurchases to reduce share count and generate per-share earnings growth that way. So while I agree that buybacks are a form of "payout", you can't really treat them as equivalent to dividends in a calculation like this.<br /><br />At least that's how it looks to me, unless I'm missing something important.<br />3rdMomenthttp://3rdmoment.blogspot.com/noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-90210900247105642862015-01-03T13:24:49.745-05:002015-01-03T13:24:49.745-05:003rd Moment,
The way in which S&P calculates un...3rd Moment,<br />The way in which S&P calculates units is fuzzy. In fact, the number of units used by S&P has remained remarkably stable, which is surprising given the volume of buybacks over the last decade. One possibility was that stock issues had offset buybacks and it is to check this that I did my post on buybacks, where I also looked at aggregate stock issues each year. In fact, if the unit number reflects buybacks, it should have dropped by about 15% in the last 5 years and it has not.<br />One solution is to bypass the index entirely and work with overall market cap, earnings, dividends and buybacks. That is easy to do, but getting a growth rate in these earnings is close to impossible. In my spreadsheet, I do offer the choice of a fundamental growth rate which should not have any double-counting effect in it.Aswath Damodaranhttps://www.blogger.com/profile/12021594649672906878noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-49098901543640443902015-01-03T12:01:03.190-05:002015-01-03T12:01:03.190-05:00Thanks for the reply, but it still appears that ev...Thanks for the reply, but it still appears that even the top-down estimates are estimates of *per-share* earnings (i.e. per index share) which reflects the changes in the index divisor, which itself reflects the effect of buybacks. <br /><br />For example, in your spreadsheet you list an earnings forecasts 135.83 for 2015. Looking at the spreadsheet "sp-500-eps-est.xlsk" from the S&P website, the 135.83 figure is in cell M76, which is clearly labeled as a forecast of "12 MONTH EARNINGS PER-SHARE." Both the top-down, bottom up, and realized values in this spreadsheet are all presented as values per-share (i.e. per "share" of the index). <br /><br />The realized value for this number will be the total aggregate operating earnings for the index firms, divided by the index divisor. The index divisor will be adjusted to already reflect the reduced share counts that come from any (net) buybacks that occur. <br /><br />So it still seems to me that by using forecasts of per-index-share earnings, you are in effect double counting buybacks.<br /><br />More on the methodology for index calculations including the divisor and index EPS can be found here:<br />http://www.spindices.com/documents/index-policies/methodology-index-math.pdf<br />3rdMomenthttp://3rdmoment.blogspot.com/noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-13560218597301810382015-01-03T10:29:24.237-05:002015-01-03T10:29:24.237-05:00Why do you compare ERP to Baa rated bonds alone &a...Why do you compare ERP to Baa rated bonds alone & not to the 'average' bond since you are deriving ERP from an average equity i.e., S&P 500? Also why do you compare the ERP/Default Spread ratio and not the difference?Anonymousnoreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-76721050131029394712015-01-03T07:37:27.845-05:002015-01-03T07:37:27.845-05:003rdMoment,
It is precisely to avoid the double cou...3rdMoment,<br />It is precisely to avoid the double counting that I use the top-down estimates. These are estimates of aggregate earnings for the S&P 500, rather than the one obtained by adding up individual per share growth growth rates. That would have yielded a growth rate of 11.50%. <br />On the GDP question, you could look at world capitalization as a percent of world GDP, but I am not sure what you would read into it. Much of the world's businesses were private until a few years ago and you would expect the ratio to increase over time.Aswath Damodaranhttps://www.blogger.com/profile/12021594649672906878noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-11203157582648672572015-01-03T00:23:29.471-05:002015-01-03T00:23:29.471-05:00Thanks for a great post, I really like your approa...Thanks for a great post, I really like your approach to estimate the ERP. I did however stumbled on you thoughts of the Buffet-estimate. What if using the estimate but consider world gdp growth combined with US gdp? Where "world gdp growth" for eg is defined by US top export countries and weight to US current account... / mr. pAnonymousnoreply@blogger.com