CFA 2018 r15 equity market valuation

Estimating a Justified P/E Ratio 2.1 Neoclassical Approach to Growth Accounting 2.2 The China Economic Experience 2.3 Quantifying China’s Future Economic Growth 2.4 Equity Market Valu

Introduction

• Estimating a Justified P/E Ratio

• Relative Value Models

2 Estimating a Justified P/E Ratio

2.1 Neoclassical Approach to Growth Accounting

2.2 The China Economic Experience

2.3 Quantifying China’s Future Economic Growth

2.4 Equity Market Valuation

2.1 Neoclassical Approach to Growth Accounting

To estimate equity valuation we need to estimate earnings growth rate

Assume earnings grow at the same rate as output (GDP)

Growth rate of GDP can be estimated using the Cobb-Douglas function

Y = A f(K, L)

2.2 The China Economic Experience

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2.3 Quantifying China’s Future Economic Growth

Estimating growth rates given elasticities, growth in TFP, growth in capital stock and growth

in labor input

2.4 Equity Market Valuation

• Translate macroeconomic forecasts into corporate cash flow forecasts

• H-model

• For emerging markets H-Model is useful: High initial growth which tapers

down

Example 2 The S&P China BMI Index on 30 September 2009 is 358 Forecasted 12-month

earnings per share for the composite are 18.00 RMB, and the current annual dividend rate

for the composite is 7.90 RMB Assuming an 8.0 percent inflation-adjusted equity discount

rate, a 30-year decline in dividend growth rates from an initial growth rate of 8.25 percent,

and a terminal sustainable growth rate to perpetuity of 4.25 percent, compute the composite index price level implied by the H-Model Computed the justified p/e implied by such price

level

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DDM and Macroeconomic Forecasts

3 Top-Down and Bottom-Up Forecasting

Top Down

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Using Both Forecasting Types

• Example 4 shows which forecasting approach is suitable for what situation

• At times can use both methods

• Bottom up method generally gives inflated estimates

• However, bottom up approach can help identify potential issues with ‘too

big to fail’ financial institutions

• Bottom up forecasts depend on consensus earnings estimates… hence more optimistic than top-down heading into a recession and more pessimistic

when coming out

• Read examples 5, 6 and 7

4 Relative Value Models

Model Description

Yardeni Model E1/P0 = yB - d x LTEG

P/10-year MA (E)

Tobin’s q and

equity q

Fed Model: Compares S&P500 forward earnings yield and year Treasury yield

10-Example 10 S&P 500 forward earnings yield is 5% and 10-year T-note yield is 4.6% Are

stocks overvalued or undervalued?

Equities undervalued!

Fed Model: Compares S&P500 forward earnings yield and 10-year

Treasury yield

Yardeni Model

E1/P0 = yB - d x LTEG

yB is yield on A-Rated corporate bonds

d is weighting factor measuring importance market assigns to earnings projections

Example 12

With d = 0.05, equities are overvalued

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Yardeni Model

10 year moving average price earning ratio

P/10-year MA (E)

Example 13

P/10-year MA (E)

Tobin’s q

Tobin’s q = market value of company/ replacement cost of assets

Equity q = market value of equity/ net worth of assets (based on replacement cost)

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Conclusion

1 Estimating growth rates

2 H-Model

3 Dividend Discount Model

4 Top-Down and Bottom Up Approaches

5 Relative Value Approaches (Exhibit 17)

Example and Practice Problems