Let’s start by assuming that the price of the S&P 500 accurately reflects the present value of its expected future cash flows, and also assume that investors are using a constant growth model to value it (ie, the perpetuity formula).

We know that:

The current price of the S&P 500 index = $2,810

And can make a reasonable guess that:

The ROE of the S&P 500 likely to be approximately 16% under the new tax policy;

Shareholder’s Equity was approximately $815 at the end of December; and

The sustainable growth rate of the S&P 500 is approximately 5%; and

Use the facts and assumptions above to answer the following questions:

What payout ratio is consistent with the 16% ROE and 5% growth rate we’ve assumed here?

What reinvestment rate does this imply?

What Cost of Equity must the market be assuming, if the S&P 500 is priced “correctly”?

Now use this estimate to calculate the risk premium for the US stock market: if the interest rate on 10 year treasury bonds (our proxy for the risk free rate) is currently 2.6%, then what is the implied risk premium for US equities?