Adjustment Rate: Changes to Valuation Method

I have decided to change one of the components of the valuation method. The Adjustment Rate. If you remember from previous postings the Adjustment Rate was:

((Dividend Yield / Historical Dividend Yield) ^ (1/20)) - 1

The historical dividend yield we used was different for stocks (5.5%), equity funds (4.5%) and small cap equities.

The new adjustment rate will be based on the P/E ratio:

((Historical PE / PE) ^ (1/10)) - 1

Although I prefer to use dividends for valuation purposes some markets and sectors have different payout ratios when it comes to dividends (for example the stocks in the FTSE100 pay out a much higher proportion of their earning than stocks in the S&P500).

You'll also notice I have used a discount period of 10 years as opposed to 20 in the previous method. As the adjustment rate only uses negative values this will increase the harshness of the adjustment for more expensive stocks.

The historical PE ratio I will use will be 10. I have chosen a conservative number to ensure the projected returns are still attainable. This figure will be true for all funds and large cap stocks. For small caps a maximum historical PE of 11.4 will be used. In the case of emerging market funds a PE of 11.1 will be used and similarly a small cap emerging market fund will use a historical PE ratio of 12.5 in its calculations.

As before only negative values for the adjustment rate will be used to give the final expected return estimate.

So the Total Expected Return will be:

Dividend Yield + Growth Rate + Adjustment Rate

Over the new few days I will be updating the lists of funds and stocks to reflect these changes.