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. It is a part of a larger framework for making forecasts about market expectations.
The model states that:
Expected Returns= Div1 /P0 + i + g - ΔS + Δ (P/E)[1]
Div1 = dividend in next period (period 1 assuming current t=0)
P0 = current price (price at time 0)
i= expected inflation rate
g= real growth rate in earnings (note that by adding real growth and inflation, this is basically identical to just adding nominal growth)
ΔS= changes in shares outstanding (i.e. increases in shares outstanding decrease expected returns)
Δ(P/E)= 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 Fed Model. Under the Fed model, the earnings yield is compared to the 10-year treasury bonds. If the earnings yield is lower than that of the bonds, the investor would shift their money into the less risky T-bonds.
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.