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The Risk Premium Factor: A New Model for Understanding the Volatile Forces that Drive Stock Prices by Stephen D. Hassett

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Chapter 5

Application to Market Valuation

The Risk Premium Factor (RPF) Model shows that the market is driven by three things: earnings, growth, and interest rates. Interest rates are the major driver of change in market price-to-earnings (P/E) ratios. The RPF Model makes it easy to test various future scenarios such as the impact of changes in inflation or earnings. Growth drives value, but not all sources of growth are equal. Earnings increases driven by revenue imply that a company can sustain long-term growth and are much more valuable than earnings driven by cost reduction. Top-line growth that drives earnings can lead to P/E multiple expansion. The RPF Model makes it easy to understand why.

Many people look at the market and valuation as a black box driven by emotion, leaving many managers unsure what strategies they can pursue to increase shareholder value. This section discusses the lessons that managers can draw from this simple model and apply it toward correcting some common misconceptions concerning market valuation. First let's reexamine the constant growth equation and the RPF Model:

Unnumbered Display Equation

This tells us that only three things matter:

1. Earnings.

2. Growth.

3. Interest rates, which drive cost of capital and embody real interest rates.

P (valuation) will increase or decrease in direct proportion to E (earnings), and changes in interest rates have the inverse impact—rising ...

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