INCORPORATING CYCLICALITY INTO VALUATIONS

The previous sections have described how valuations vary with the cycle and how those variations are tied to the macroeconomy. These variations imply that investors are not rewarded for most of the earnings growth when it occurs, but rather before it occurs during the Hope phase, and when investors get overly optimistic about the future during the Optimism phase.

This section describes how to adjust valuation analysis to take this cyclicality into account in a quantified way. In our view, the long run growth assumptions for company profits and payout ratios should remain relatively stable over time as long as there are no big structural shifts in the growth rate of the underlying economy. This has been a reasonable assumption for both the United States and Europe over the last few decades, and we think it still remains so. If long run growth assumptions are relatively stable, interest rates and the equity risk premium become key drivers of fluctuations in the P/E multiple over time as shown in equation (5.1).

Interest rates are observable but the ERP is not. The fact that the ERP cannot be directly observed is an even bigger challenge for valuation when you accept that it is likely to change over time. Our recommended solution to this problem is to estimate the ERP by fixing the long run growth assumption and turning the Dividend Discount model on its head to calculate what risk premium is required at any given point in time, in order for ...

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