Let’s start by assuming that the price of the S&P 500 accurately reflects the present value of its expected future cash flows, and also assume that investors are using a constant growth model to value it (ie, the perpetuity formula).
We know that:
The current price of the S&P 500 index = $2,810
And can make a reasonable guess that:
The ROE of the S&P 500 likely to be approximately 16% under the new tax policy;
Shareholder’s Equity was approximately $815 at the end of December; and
The sustainable growth rate of the S&P 500 is approximately 5%; and
Use the facts and assumptions above to answer the following questions:
What payout ratio is consistent with the 16% ROE and 5% growth rate we’ve assumed here?
What reinvestment rate does this imply?
What Cost of Equity must the market be assuming, if the S&P 500 is priced “correctly”?
Now use this estimate to calculate the risk premium for the US stock market: if the interest rate on 10 year treasury bonds (our proxy for the risk free rate) is currently 2.6%, then what is the implied risk premium for US equities?