How to Value S&P 500 Index

The S&P 500 Index (SPX) contains the 500 large market cap companies listed on the US stock exchanges. As of Nov 16, 2020, Information Technology, Consumer Discretionary, Health Care and Communication Services constitutes 64% of the index. The top six largest market cap companies on SPX as of mid November are Apple, Microsoft, Amazon, Alphabet (Google) and Facebook. Energy and Real Estate companies represent only 4% of the index given the ripple effect of the pandemic on the public equities, punishing low growth, asset intensive companies with higher net debt burden and low dividend yield while rewarding high growth companies with low net debt, low dividend yield, high P/B and P/E ratios. The sector weights of S&P 500 Index as of November 16, 2020 are displayed in the following graph and table.

S&P500 Sector Weights
S&P500 Sector Weights

Valuation of the Index

The valuation of SPX is built upon the main pillars of valuation of its cashflows, growth and risk. The cash flows represent cash flows to common shareholders of companies which include dividends and buybacks. The growth of these cashflows is represented by the growth rate of the dividends and buybacks during the high growth period, prior to reaching the terminal year; in terminal year, the growth is then represented by the terminal growth rate which is capped by the risk-free rate. The standard proxy for the risk-free rate is the 10-year treasury yields in the mature markets such as United States. Finally, the risk of these cashflows is represented by the cost of equity. Cost of equity is determined by the relative risk of the stocks with respect to the overall market, measured by beta, and the market equity risk premiums (ERP) over and above the risk-free rates (r_f). Since the S&P500 is a proxy for the entire US developed, mature market, the beta in this case is 1. Hence:

In order to forecast buybacks and dividends of SPX, consider the forecast of the earnings of SPX for a period of 5 years (which is the high growth term) prior to bringing the valuation to a close in the terminal year. As many analysts forecast SPX earnings for a period of two to three years forward under either a bottom up or a top down approach, in this analysis, we will use the average of the bottom up forecasts sourced from Refinitiv as well as the top down estimates of earnings provided by Yardeni Research for 2020 and 2021.

Considering the YoY growth rate of the earnings provided by the analysts, and knowing that this growth rate will eventually be capped and reach the risk-free rate in the terminal year, the compounded growth rate of the earnings during the 5 year high growth period is calculated to be 3.7%. Since the earning estimates and current low interest rate environment has already included the impact of COVID-19, the adjustment of this growth rate for the impact of pandemic is no longer required; however, since the pandemic has severely impacted the earnings in 2020 and 2021, we can control for the impact of COVID-19 on the forecast of future earnings through integration of a scalar, which represents the earning loss recouped by the end of the fifth year (2024F). If this scalar is set to 100%, it means all the earning lost in 2020 due to the pandemic is recouped by 2024, and if this scalar is set to 80%, it means only 80% of the earning loss is recouped by 2024. This scalar is used in calculation of the earnings in the final year prior to the terminal year, in 2024 using the following formula:

The terminal year earnings is the earnings in 2024 grown at the terminal growth rate, in this case, the risk-free rate of 0.89% as of Nov 16, 2020.

Dividends and buybacks are determined by calculating the dividend and buyback payout ratio through out the forecast period and applying the ratio to the earnings in the corresponding years to get the cashflows to equity holders. Given the Dividend + Buyback and Earnings Per Share levels of the index in 2019, the 2019 payout ratio stands at 89.75%. The best approach to arrive at a continuous payout ratio throughout the forecast period is to find the term year payout ratio given proxies for term growth rate and term return on equity (ROE) of the index, using the following: