US stock market is in a tough week as 10-year yield rises.
It’s interesting to review the CAPM formula and its relation with multiple.
Assumptions:
-
- Market risk premium (MRP) = 6%
- Before covid, risk-free rate = 10-year yield = ~2%
- 10-year yield basically goes to 0.5% in 2020 and approaches now to 1.5%
- Discount = Risk-free rate + MRP, assuming beta is 1
- Earnings terminal growth rate = 3%
- Earnings multiple = 1/(Discount – Terminal growth rate)
| Risk-free rate | Discount | Multiple |
|---|---|---|
| 2% | 8% | 20.0x |
| 0.5% | 6.5% | 28.6x |
| 1% | 7% | 25.0x |
| 1.5% | 7.5% | 22.2x |
When market was performing like it’s 1% but realized that it’s actually 1.5%, the correction is ~9%.
When market was performing like it’s 0.5% but realized that it’s actually 1.5%, the correction is ~22.5%.