‘Big four’ valuation variables—cash, growth, ERP, and risk-free rate--will continue to drive stock market surge, Damodaran opines

As usual, Prof. Aswath Damodaran (NYU Stern School of Business) is among the first to assess how the recent surge in the stock market impacts valuation. Right now, with both the Dow and S&P 500 hitting record highs, “the natural impulse is to look for signs of overvaluation,” he writes in the most current Musings on Markets, “but there are good reasons why U.S. stock prices are elevated: cash flows are high, growth looks good, the macro risks seem to have faded (at least somewhat), and the alternatives are delivering lousy returns.”

On each of the four major variables of public company value, the U.S. equity market is also looking at "good" numbers right now, Damodaran says. “The cash returned to investors by U.S. companies has rebounded strongly from post-crisis lows, earnings growth is reasonable, the risk-free rate is at a historic low, and the equity risk premium, while not quite at pre-crisis levels, has declined significantly over the last year.” With regard to the ERP, in particular, Damodaran estimates a “historical” premium of 4.20% for U.S. stocks in 2013, based on 1928-2012 data. An implied approach yields 5.78% at the start of 2013, lower than the ERP at the start of last year, he says, “but still at the high end of the historical range.”

In the near term, U.S. stocks remain vulnerable to two possibilities. One is that another macro crisis will pop up (Italy, Spain, Portugal, or a non-EU "black sheep"), which will cause ERPs to jump back to the 6%-plus levels that we have seen so often in the last five years. “The other is a sudden surge in interest rates, unaccompanied by better earnings or higher earnings growth,” he says, which will adversely affect all risky asset classes (corporate bonds, real estate, etc.) As a valuation advisor—and based on his current assumptions—Damodaran believes the current surge is “justified,” but as an investor, “I am going to stop worrying about the overall market and go back to finding undervalued companies.”