Considerasimpleexample.Assumethatyouhaveanindex
tradingat 700 andthattheaveragedividendyieldofstocksin
the index is 5 percent. Earnings and dividends can be
expectedtogrowat 4 percentayearforeverandtheriskless
rateis5.4 percent.Ifyouuse amarket riskpremiumof 4
percent, the value of the index can be estimated.
At its existing level of 700, the market is slightly overvalued.
ILLUSTRATION 5.6: Valuing the S&P 500 Using a
Dividend Discount Model: January 1, 2005
On January 1, 2005, the S&P 500 index was trading at
1,211.92.Thedividendyieldontheindexwasonly 1.81%,
butincludingstockbuybacksincreasedthemodifieddividend
yieldto2.9%.Analystswereestimatingthattheearningsof
thestocksintheindexwouldincrease 8.5%ayearforthe
nextfiveyears.Beyondyear5,theexpectedgrowthratein
earningsanddividendswasexpectedtobe4.22%,setequalto
theTreasurybondrateontheassumptionthattheTreasury
bondrateisareasonableproxyfornominallong-termgrowth
in the economy. We used a market risk premium of 4%,
leading to a cost of equity of 8.22%: