Finance:Grinold and Kroner Model
The Grinold and Kroner Model is used to calculate expected returns for a stock, stock index or the market as whole.
Description
The model states that:
[math]\displaystyle{ \mathbb{E}[R] = \frac{\mathrm{Div}_1}{P_0} + i + g - \Delta S + \Delta (P/E) }[/math][1]
Where [math]\displaystyle{ \mathbb{E}[R] }[/math] are the expected returns
- [math]\displaystyle{ \mathrm{Div}_1 }[/math] is the dividend in next period (period 1 assuming current t=0)
- [math]\displaystyle{ P_0 }[/math] is the current price (price at time 0)
- [math]\displaystyle{ i }[/math] is the expected inflation rate
- [math]\displaystyle{ g }[/math] is the real growth rate in earnings (note that by adding real growth and inflation, this is basically identical to just adding nominal growth)
- [math]\displaystyle{ \Delta S }[/math] is the changes in shares outstanding (i.e. increases in shares outstanding decrease expected returns)
- [math]\displaystyle{ \Delta (P/E) }[/math] is the changes in P/E ratio (positive relationship between changes in P/e and expected returns)
One offshoot of this discounted cash flow analysis is the disputed Fed model, which compares the earnings yield to the nominal 10-year Treasury bond yield.
Grinold, Kroner, and Siegel (2011) estimated the inputs to the Grinold and Kroner model and arrived at a then-current equity risk premium estimate between 3.5% and 4%.[2] The equity risk premium is the difference between the expected total return on a capitalization-weighted stock market index and the yield on a riskless government bond (in this case one with 10 years to maturity).
References
- ↑ Richard Grinold and Kenneth Kroner, "The Equity Risk Premium," Investment Insights (Barclays Global Investors, July 2002).
- ↑ Richard Grinold, Kenneth Kroner, and Laurence Siegel, "A Supply Model of the Equity Premium," in B. Hammond, M. Leibowitz, and L. Siegel, eds., Rethinking the Equity Risk Premium, Charlottesville, VA: Research Foundation of CFA Institute, 2011.
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