Question

You have gathered the following data, all of which is dated March 29, 2018:

S&P 500 Index level: 2,640.87

S&P 500 forward earnings estimate: $160.15

S&P 500 P/E (forward): 16.49

S&P 500 P/B: 3.27

10-year T-Note yield: 2.74%

CPI inflation rate (year-over-year change): 2.40%

What is the earnings yield for the S&P 500? Based on the predictions of the Fed Model, are U.S. equities undervalued or overvalued? Why is this the case? To receive full credit, you must show all of your work in the space provided below.

What is the “fair value” P/E ratio for the S&P 500 according to the Fed Model? What is the “fair value” estimate for the S&P 500 index level according to the Fed Model? To receive full credit, you must show all of your work in the space provided below.

What is the “fair value” P/E ratio for the S&P 500 based according to the Rule of 20 and the CPI inflation rate? Are U.S. equities undervalued or overvalued according to this measure? Why is this the case? To receive full credit, you must show all of your work in the space provided below.

Use the constant growth formula for the price-to-book ratio (P/B) to estimate an expected return for the S&P 500 assuming a growth rate of 5%. To receive full credit, you must show all of your work in the space provided below.

Answer 1

Greetings,

Earnings Yield on an Index = Expected Earnings / Current Index Value = 160.15/2640.87 = 6.06%.

10 year Treasury yield is only 2.74% which is less than earnings yield on the index. It means US equities are undervalued because at lower price, yield is more. Since bond market provides low return than stock market, people would prefer stocks - it means they find the stocks to be undervalued.

Fair value as per Fed model would be the level at which both bond and stock market provide equal return = 2.74%. So EY of Index should be 2.74%

Fair Value of P/E ratio = 1/0.0274 = 36.50 times

So FV of Index = 36.50×160.15 = 5845 approx.

Infact this proves our point futher that US equities are undervalues as justified price (5845)> actual price (2640.87)