Equity Forecasting

Historical Statistical Approaches

Historical statistical approaches involve the collection of data from past returns and using them to extrapolate future performance. Using a pure-historical returns approach to forecast equity market returns is complicated because equities have a high standard deviation relative to their mean returns. This means data can often be misleading.

Generally, developed economies’ equity returns tend to range from 4.5% to 9.5%.

Discounted Cash Flows Approach

Building on the constant growth, or Gordon Growth Model, is the Grinold-Kroner Model. While simplistic, the constant growth model provides a distinct advantage over historical estimates. It attempts to look toward the future to project development and growth rather than simply capturing what the past has delivered. The Grinold-Kroner Model expands on the constant growth model by allowing for adjustments from share repurchases and overall market valuations.

Grinold-Kroner Model

$$ E(R_i) \approx \frac {D}{P} + (\% \Delta E – \% \Delta S) + \% \frac {\Delta P}{E} $$

Where:

\(E(R_i)\) = Expected equity return.

\(\frac {D}{P}\) = Dividend yield.

\(\% \Delta E\) = Expected percentage change in total earnings.

\(\% \Delta S\) = Expected percentage change in shares outstanding.

\(\% \frac {\Delta P}{E}\) = Expected percentage change in the P/E ratio.

It is important to note that the equation contains a negative relationship with share repurchases. A rise in share repurchases will decrease the expected equity market premium. All other components of the Gordon Growth Model are present, including a breakout for inflationary expectations and a change in the price-to-earnings ratio.

Singer-Terhaar Model

The Singer-Terhaar Model builds on the international CAPM approach by assuming a wholly segmented market, then a completely integrated market, and then adding an adjustment for the degree of integration.

International CAPM

$$ R_i = R_f + \beta(R_m – R_f) $$

Where:

\(R_i\) = Expected return.

\(R_f\) = Risk-free rate.

\(\beta\) = Beta.

\(R_m\) = Expected equity market return.

Singer and Terhaar Analysis

$$ \begin{align*} ERP_i & = \left[ \left(\text{Degree of integration} \right) \times \sigma_i \times \rho_{(i,m)} \times \frac {(ERP_m)}{\sigma_m} \right] \\ & + \left[ \left(\text{Degree of segmentation}) \times \sigma_i \times \frac {((ERP_m)}{\sigma_m} \right) \right] \end{align*} $$

Where:

• \(ERP_i\)=Equity risk premium of a partially integrated market.
• \(\rho_{(i,m)}\)=Correlation of market with global portfolio.

Explanation

The equity risk premium is the return over and above the risk-free rate. It is hard to forecast the equity premium, and analysts have to decide on the degree of integration/segmentation. It is noteworthy that equity and bond markets of developed countries are highly integrated; hence, a range of 0.75–0.90 is suitable. On the other hand, equity and bond markets of emerging markets are less integrated, so a range of 0.50–0.75 is more appropriate. Analysts are advised to couple forecasts with other methods of analysis.

Question

Which of the following inputs to the Grinold-Kroner Model will most likely reduce the expectations for an equity market premium?

1. An increase in growth.
2. An increase in the payout ration.
3. An increase in share repurchases.

Solution

The correct answer is C.

An increase in outstanding shares would decrease the expected return. Note that share repurchases are a way of returning cash to investors. Shares outstanding are the denominator in the price per share formula, while total equity is the numerator. Therefore, all things equal, a larger denominator will reduce the quotient, which is the price per share. This is synonymous with capital depreciation or reducing return.

A is incorrect. An increase in growth would increase the expectations for an equity market premium. The Grinold-Kroner Model includes the real growth rate in earnings as one of its inputs. An increase in the real growth rate in earnings would increase the expected return on a stock or stock market index.

B is incorrect. An increase in the payout ratio would also increase the expectations for an equity market premium. The Grinold-Kroner Model includes dividend yield as one of its inputs. An increase in the payout ratio would increase the dividend yield, increasing the expected return on a stock or stock market index.

Asset Allocation: Learning Module 2: Capital Market Expectations – Part 2 Forecasting Asset Class Returns; Los 2(c) Discuss approaches to setting expectations for equity investment market returns