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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 11

Using the RPF Model for Investment and Business Strategy

This chapter recaps the major points of the book, then applies the model and tools to investment analysis, including identifying and exploiting bubbles, investing in individual companies, applying the Risk Premium Factor (RPF) Model to business decision making, value destruction, and value creation.

The RPF Model exposes the elegant simplicity of valuation and highlights the importance of the factors that drive value. This chapter will highlight and summarize some of the value-creating approaches discussed in this book. Let's begin with a recap of the key elements of the RPF Model:

1. The equity risk premium (ERP) is not a constant but a stable factor applied to the risk-free rate (10- or 30-year Treasury yields)—the risk premium factor (RPF).

2. The RPF is consistent with the loss aversion coefficient associated with Prospect Theory (Kahneman and Tversky, 1979, 1992).

3. The Risk Premium Factor Valuation Model (P = E/(Rf × (1 + RPF) – (Rf – IntR + GR)) effectively explains both price-to-earnings (P/E) ratio and Standard & Poor's (S&P) 500 Index levels using readily available information and simplifying assumptions.

4. By applying the current RPF and long-term assumptions for growth and real interest rates, it can be applied to predict current P/E and price of the S&P 500 and simplified to:

a. P = E/(Rf × (1 + RPF) – (Rf – 2.0 percent) + 2.6 percent))

b. P/E = 1/(Rf × (1 + RPF) – (Rf – 2.0 percent) + 2.6 percent)) ...

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