US Equity Risk Premium

An R implementation of the methodology laid out in Deriving Equity Risk Premium Using Dividend Futures (Časta, 2021), extended to accommodate buybacks. The US equity risk premium is backed out from future contracts tracking the S&P 500 Annual Dividend Index and net S&P 500 buybacks (gross annual buybacks less share issuance), forecast as a proportion of the consensus S&P 500 earnings. Both the future contract quotes and the earnings are interpolated via the natural cubic spline method in order to facilitate annual discounting.

Net Buybacks

Net buybacks as a percentage of S&P 500 earnings, initially set to a user-input base (year 0), linearly converge to a terminal ratio over the course of the explicit 20 year forecast period. In perpetuity, the ratio is consistent with the concept of the total sustainable payout sustainable payout (net buybacks + dividends as a share of earnings), given as

sustainable payout = 1 - g/ROE

with g and ROE denoting the long-run nominal earnings growth rate and the terminal aggregate return on equity of the S&P 500 index, respectively.

User Input

• buybacks = base (year 0) S&P 500 net buybacks/earnings ratio
• sus_payout = long-run (year20 onwards) total target/sustainable payout ratio
• g = long-run S&P 500 earnings/cash flow growth rate
• P = current S&P 500 index value
• futuresXX = S&P 500 annual dividend futures
• earningsXX = S&P 500 annual forecast earnings
• rfXX= USD riskless rate (SOFR)

Data Source

The dividend futures (settlement schedule available through the CME Group) and the zero SOFR curve are obtained from LSEG Workspace. The explicit consensus S&P 500 earnings forecast is provided by Yardeni Research and extrapolated forward via a method from Aswath Damodaran, who also computes the index ROE, the index unit conversion factor and historical payout ratios. The data for historical S&P 500 earnigns, gross buybacks and dividends originates from S&P Global while historical share issuance is sourced from CapitalIQ. The long-run growth rate comes from the Federal Open Market Committee Summary of Economic Projections. Sample data is available in the enclosed Excel files (futures.xlsx, sofr_curve.xlsx, s&p_earnings.xlsx, s&p_payout.xlsx).

References

The original ČNB working paper:

Časta, M. (2021). Deriving Equity Risk Premium Using Dividend Futures. ČNB Working Paper Series 1/2021. 
https://www.cnb.cz/export/sites/cnb/en/economic-research/.galleries/research_publications/cnb_wp/cnbwp_2021_01.pdf