Are Stocks Overvalued? A Survey Of Equity Valuation Models

July 28, 2015

Absolute Valuation Models

We begin with a discussion of the two absolute valuation models named in Table 1: Model 1, the average of dividend yield and earnings yield; and Model 2, dividend yield plus historical average real growth.

Are Stocks Overvalued

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Model 1, the simple average of dividend yield and earnings yield, is a quick and easy method to calculate the expected return of the equity market. This model accounts not only for income received by investors, but also captures growth from reinvested earnings and recognizes historically documented share dilution (i.e., the difference between new share issuances and buybacks).

The short-term and long-term return forecasts of the U.S. equity market, using Model 1, are plotted in Figure 2. Recall that Figure 1 illustrates the much greater uncertainty of shorter term forecasts compared to longer term forecasts. Therefore, as we would expect, Figure 2 shows that over a one-year horizon the model has almost zero predictive power, with an R2 of 3%, but when the horizon is lengthened to 10 years, the explanatory power jumps to 31% (56% correlation).

As of June 2015, Model 1 forecasts the one-year U.S. equity yield to be 3.7%, the average of 5.4%, the trailing S&P 500 one-year earnings yield,4 and 2.0%, the trailing S&P 500 one-year dividend yield.

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