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by Richard
W. Kopcke and Matthew S. Rutledge
No. 1, January 2004 - August 2004
Motivation for the Research
After the sharp run-up in stock prices during the
bull market of the late 1990s and their subsequent collapse
in 2001-2002, the prices of equities as measured by the S&P
500 are once again uncommonly high relative to companies’
current and prospective earnings. This raises the question,
Are stock prices too high relative to the underlying value
of the companies they represent?
If this is the case, it implies that valuations may be
destined to collapse, potentially derailing the recovery.
Research Approach
The authors summarize the performance of the stocks that comprised
the S&P 500 index during the recent bull and bear markets,
comparing their valuations with previous experience since
the 1940s. They then employ an analytical model, substituting
actual or estimated values for key variables to derive theoretical
estimates for the risk premium on equity. Combining these
estimates with the real rate of return on government bonds,
they derive the real discount rate required of equity. Finally,
the authors use the model of equity prices to explore the
contributions of the factors that are likely to influence
the price of equity in the future.
Key Findings
- Current valuations do not necessarily mark a bubble: Rapidly
growing earnings and high returns on capital, consistent
with a return to full employment, could justify prevailing
prices.
- The results imply that shareholders’ risk premium
for equity rose during the 1990s; should this premium fall,
as is likely with the recovery of business conditions, it
could offset much of the negative effect of rising real
interest rates on stock prices.
- If earnings grow at least half as fast as analysts expect,
current prices might accommodate a one- or two-percentage-point
increase in the real rate of interest. (Analysts’
expectations of earnings growth are currently far higher
than the projected growth of potential GDP.)
- Variations in the valuation of the largest companies
can account for a very large share of the change in the
value of the entire S&P 500 in both bull and bear markets,
and the prices of stocks relative to earnings for the largest
companies are also more volatile than those of smaller companies.
Implications
Because valuations of the largest companies are so important
in determining the value of the S&P 500 index, the prospects
for these companies’ earnings growth are a key determinant
of whether current valuation of the index is reasonable. Another
key variable is the required equity premium, in turn influenced
by earnings growth and the return on capital, especially for
the largest companies in the index.
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