Russell 2000 is overvalued even considering an economic growth rate of 3.68% vs 3.11% in the last decade

The economic growth rate is one of the most important factor in the indexes’ valuations (see Russell 2000’s overvaluation could be more than 60%). In this publication we explain the fundamentals of our estimation of this issue and its implications on Russell 2000’s dividends growth. These calculations has been essential to estimate the overvaluation of Russell 2000.

This article could be also interesting for analyst or investors that could be in search of fundamentals to base their expectations for the economic growth rate.

The growth of the dividends is expressed by g. It depends on the evolution of the EPS and the Pay Out ratio. As we have already explained, the Pay Out ratio has very little space to grow when it is already discounting a ROE of 14.05%, clearly above 8.17% that is the maximum since 1995 for Russell 2000. So all potential growth is expected to come from EPS.

The growth in EPS is very correlated with the growth of GDP in the long term (See Chart 5). In the last 23 years, the growth of GDP in the USA has averaged 4.11% compared with 4.16% of EPS.

Chart 5

In order to estimate future growth, we have make the assumption that it will be more or less in line with the growth of the regression based on the period between 2000 -2017. The valuation model is very sensitive to this factor, and because of that we will do one thousand simulations taking g values centered in 3.68% with a standard deviation of 0.55%. As we can see in Chart 6 below, all the different historic growth from the year 2000 for GDP is a little further away from central expected growth by one standard deviation. In this sense, many of the possible errors in this parameter are already considered in the valuation model.

Chart 6

To understand the framework of this publication and the relevance for Russell 2000’s valuation, please consult: Russell 2000’s overvaluation could be more than 60%