2.4 Equity Market Valuation This section addresses LO.c: LO.c: Demonstrate the use of the Cobb-Douglas production function in obtaining a discounted dividend model estimate of the intri
Trang 1Equity Market Valuation
1 Introduction 3
2 Estimating a Justified P/E Ratio 3
2.1 Neoclassical Approach to Growth Accounting 3
2.2 The China Economic Experience 3
2.3 Quantifying China’s Future Economic Growth 4
2.4 Equity Market Valuation 5
3 Top-Down and Bottom-up Forecasting 6
3.1 Portfolio Suitability of Each Forecasting Type 6
3.2 Using Both Forecasting Types 7
4 Relative Value Models 8
4.1 Earnings-Based Models 8
4.2 Asset-Based Models 10
Summary 11
Examples from the curriculum 14
Example 1 The Neoclassical Approach to Growth 14
Example 2 Equity Market Valuation Using Dividend Discount Models 15
Example 3 Applying Valuation Methodology to a Developed Economy 16
Example 4 Growth Model Questions 18
Example 5 Comparing and Evaluating Top-Down and Bottom-Up Forecasts 19
Example 6 Earnings Forecast Revisions 20
Example 7 Bottom-Up and Top-Down Market EPS Forecasts 21
Example 8 Fed Model with US Data 21
Example 9 Fed Model with UK Data 22
Example 10 Fed Model Questions 22
Example 11 The Yardeni Model (1) 23
Example 12 The Yardeni Model (2) 24
Example 13 Determining CAPE: A Historical Exercise 25
Example 14 CAPE Questions 26
Example 15 Market-Level Analysis of Tobin’s q and Equity q 26
Example 16 Tobin’s q and Equity q 27
Example 17 Questions Regarding the Relative Value Models 27
Trang 2This document should be read in conjunction with the corresponding reading in the 2018 Level III CFA®
Program curriculum Some of the graphs, charts, tables, examples, and figures are copyright
2017, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved
Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the
products or services offered by IFT CFA Institute, CFA®, and Chartered Financial Analyst® are
trademarks owned by CFA Institute
Trang 31 Introduction
This reading demonstrates the application of economic forecasts to the valuation of equity markets We
will look at:
How to estimate a justified P/E ratio for stocks in an economy
Top-down and bottom-up forecasting
Relative value models
2 Estimating a Justified P/E Ratio
Real GDP growth is a proxy for dividend growth for companies based in that economy Developed
economies have stable long-term growth rates Emerging economies have more complicated growth
rates
2.1 Neoclassical Approach to Growth Accounting
This section addresses LO.a:
LO.a: Explain the terms of the Cobb-Douglas production function and demonstrate how the function
can be used to model growth in real output under the assumption of constant returns to scale
The Cobb-Douglas production function can be used to estimate the long-term GDP growth rate for an
α = Change in Y for a 1-unit change in K
(1 - α) = Change in Y for a 1-unit change in L
α + (1 - α) = 1
Solow Residual:
The change in total factor productivity is also called the Solow residual
Solow residual ≈∆A
A = ∆TFP
2.2 The China Economic Experience
This section addresses LO.b:
Trang 4LO.b: Evaluate the relative importance of growth in total factor productivity, in capital stock, and in
labor input given relevant historical data
We can use the historical growth of capital and labor, along with the estimates of output elasticity of
capital and labor, to figure out the source of the growth in GDP
Refer to the exhibit below, which shows the growth rate of various economies Looking at China’s
numbers we can see that its growth in total factor productivity and growth in labor input have come
down as compared to the 1978-1995 period, which has slowed down the growth rate of the real GDP
Comparing China’s numbers to European Union’s numbers we can see that China has a higher growth
rate of GDP because all three factors: total factor productivity, capital stock and labor input are growing
at a faster rate as compared to Europe
It is important to distinguish between structural factors that affect long-term trend growth and one-time
factors that only affect short-term economic growth Refer to Example 1 which shows a temporary
decrease in the growth rate of capital due to sharp increase in energy prices and at the same time strict
restrictions on environmental pollution, but in the long run the capital growth rate will come back to
normal
Refer to Example 1 from the curriculum
2.3 Quantifying China’s Future Economic Growth
If we are given the output elasticity and growth in TFP, growth in capital stock and growth in labor input,
we can estimate the growth rate of the economy
For example, let’s say the following information is provided for China for the time period 2009 – 2030
TFP growth = 2.5%
Growth in capital = 12%
Growth in labor = 1.5%
Trang 5 α = 0.5
Using this information and the growth equation we can we can estimate a short-term growth rate of
9.25 percent
However, according to the Neo classical model the high growth rate in the near term will not continue in
the future Once China has caught up to the technology of the developed countries it’s TFP growth rate
will slow down Similarly, once there is already a lot of capital per person, sustaining high capital growth
rate is difficult Also, given China’s population policy the labor growth rate will come also come down
Hence eventually the long-term trend growth rate will come down and it will be closer to the growth
rate of a regular developed country
2.4 Equity Market Valuation
This section addresses LO.c:
LO.c: Demonstrate the use of the Cobb-Douglas production function in obtaining a discounted
dividend model estimate of the intrinsic value of an equity market
We can use the Gordon growth model to value a developed market equity index using the country’s
long-term trend growth rate
V0=D0(1 + g)
r − g
Refer to Example 3 from the curriculum
Note that the long-term dividend growth rate (g) and actual dividends paid (D0) are unlikely to change,
so the most important factor determining the value of equity markets in developed economies is
changes in the discount rate (r)
However, the Gordon growth model is not appropriate for estimating the fair value of equity markets in
emerging economies such as China Notably, the Gordon growth formula uses a single estimate for
growth (g), but, as discussed in Section 2.3, there are two relevant growth rates for the Chinese
economy – a higher short-term rate, and a lower long-term trend growth rate
The H-model provides an alternative to the Gordon growth model for valuing equity markets in
economies that are experiencing a temporary period of “supernormal” growth
The first component of this equation is the Gordon growth model The second component calculates the
value that is attributable to the temporary period supernormal economic growth N is the number of
periods (years) that the economy will grow faster than the long-term trend rate This model assumes
that the short-term growth rate will experience a linear decline over a period of N years before settling
Trang 6at the long-term trend growth rate
Refer to Example 2 from the curriculum
The remainder of this section addresses LO.d:
LO.d: Critique the use of discounted dividend models and macroeconomic forecasts to estimate the
intrinsic value of an equity market
Criticisms of using dividend discount models for estimating the intrinsic value of an equity market:
Quality of inputs Economic data may be unreliable
In economies experiencing structural changes, there may be extended periods during which
corporate earnings and dividends do not grow at the same rate as overall GDP
Extreme events such as hyperinflation and currency instability can occur
3 Top-Down and Bottom-up Forecasting
LO.e: Contrast top-down and bottom-up approaches to forecasting the earnings per share of an
equity market index
3.1 Portfolio Suitability of Each Forecasting Type
Top-down analysis
In top-down forecasting, analysts begin with the macroeconomic projections of the entire economy and
work their way down to identify attractive industries or companies
Market Analysis – Here an analyst will check the valuations of different equity market to identify
markets where the expected returns is high The steps are:
Analysts can compare relative value measures for each equity market indices to its historical
value to identify equity markets that are relatively cheap or expensive
Next, the analyst can examine the trends in relative value measures of the equity market indices
to identify any momentum in the markets
Market
Analysis
Industry Analysis
Company Analysis
Trang 7 Finally the analyst can compare the expected returns of these equity markets to the expected
returns of other asset classes such as bonds, real estate and commodities
Industry Analysis – Here an analyst will evaluate different industries in the equity markets (selected in
step 1) to identify industries that are expected to outperform The steps are:
Compare relative growth rates and expected profit margins across industries
Identify industries that will benefit from expected changes in macroeconomic factors such as
interest rates, inflation, exchange rates etc
Company Analysis – Here the analyst analyzes individual companies in industries selected in step 2, to
identify companies that are expected to outperform
Bottom-up analysis
In Bottom-up analysis, analysts begin with the microeconomic projections of individual companies and
work their way up to identify attractive industries and equity markets
Company Analysis: Here an analyst analyzes individual stocks to identify which stocks are expected to
outperform, without considering the current macroeconomic conditions The steps are
List down reasons why a company’s product or service will be successful
Evaluate the company’s management, business model and growth prospects
Calculate expected returns for individual stocks using DCF models
Industry Analysis: Add the expected returns of stocks within an industry to identify industries that are
expected to outperform
Market Analysis: Add expected returns of all industries to identify equity markets that are expected to
give high returns
Refer to Example 4 from the curriculum
3.2 Using Both Forecasting Types
See Example 4 It shows which forecasting model is suitable for what situation It is often the case that
both top-down and bottom-up methods are required
Company
Analysis
Industry Analysis
Market Analysis
Trang 8Bottom-up analysis may be preferable for tactical asset allocation Bottom-up analysis, which relies on
analysts’ estimates, tends to be more optimistic than top-down analysis heading into a recession and
more pessimistic coming out of a recession However, bottom up approach can help identify potential
issues with ‘too big to fail’ financial institutions such as Fannie Mae and Freddie Mac
Top-down analysis can tell us how companies are reacting to changes in economic conditions However,
top-down analysis can be slow to detect cyclical turns in an economy
Refer to Example 5 from the curriculum
Refer to Example 6 from the curriculum
Refer to Example 7 from the curriculum
4 Relative Value Models
This section addresses LO.f and LO.g:
LO.f: Discuss the strengths and limitations of relative valuation models
LO.g: Judge whether an equity market is under-, fairly, or over-valued using a relative equity
valuation model
Relative valuation models provide a "true" measure of where the market "should" be in order to
determine if the market is overvalued, fairly valued, or undervalued Relative value can be assessed
based on either Earnings-based models or Asset-based models
4.1 Earnings-Based Models
Fed Model
The Fed Model assumes that the earnings yield on the S&P 500 should be equal to the yield on long
term U.S Treasuries If the S&P earnings yield are higher than the treasury yield, the market is
considered undervalued Similarly, if the earnings yield is lower than the treasury yield, the market is
considered overvalued
Advantages
Easy to understand and apply
Consistent with assumption that higher discount rate = lower value
Disadvantages
Ignores the equity risk premium
Ignores earnings growth
Compares a real variable to a nominal variable
Refer to Example 8 from the curriculum
Refer to Example 9 from the curriculum
Trang 9Refer to Example 10 from the curriculum.
Yardeni model
The Yardeni model is based on the Gordon growth model, but assumes that investor prefer earnings to
dividends Using the Gordon growth formula (with earnings substituted for dividends), the forecasting
earnings yield should be equal to the difference between the discount rate (r) and the growth rate (g)
For r, the Yardeni model uses the yield on an A-rated corporate bond (yB) For the growth rate (g), the
Yardeni model uses the consensus estimate of the 5-year earnings growth rate (LTEG), which has been
multiplied by a factor (d) that represents the value that investors assign to earnings forecasts
Historically, the value of d has typically been in the range of 0.1
E1
P0 = yB− d × LTEG
Like the Fed model, the Yardeni model used a market’s earnings yield to make an assessment of fair
value In this case, the hurdle rate is the growth-adjusted corporate bond yield If the earnings yield
exceeds this hurdle rate, the market is considered undervalued (and vice versa)
If the earnings yield is greater than the (growth-adjusted) corporate bond yield, the market is
undervalued (and vice versa)
Refer to Example 11 from the curriculum
Refer to Example 12 from the curriculum
As shown in Example 12, if investors place a lower value on earnings forecasts (i.e., d is lower), the
hurdle rate increases and, all else equal, a market is more likely to be considered overvalued
Advantages
Adds a risk premium component that is absent from the Fed model
Adds an earnings growth component that is absent from the Fed model
Disadvantages
The risk premium for the corporate bond yield that is used reflects default risk, not equity risk
Earnings growth forecast may not be sustainable
The earnings discount factor (d) may not stay constant over time
Controls for business cycle effects by using a 10-year moving average of real earnings
Controls for inflation by using real values
Historical data suggests that there is an inverse relationship between this measures and future
Trang 10equity returns
Can be considered mean-reverting, which means that if the current P/10-year MA(E) is low
relative to the historical average, it can be expected to increase in value (and vice versa)
Disadvantages
This model is not independent of changes in accounting rules, which is important because over
time there have been significant changes in how earnings are reported
Current earnings may be more representative of market conditions than the 10-year moving
average
Deviations from the long-term historical average PE level can persist for extended periods
Refer to Example 13 from the curriculum
Refer to Example 14 from the curriculum
Equity Q is the ratio of the market value of a company’s equity to the replacement value of its assets
minus its debt
Equity
AssetsR− Debt
For both Tobin’s Q and Equity Q, a ratio less than 1.0 indicates that assets can be purchased for below
replacement cost, which means that the company is therefore undervalued Similarly, a value greater
than 1.0 indicates that the market values the company’s assets more than their replacement cost, so
additional investment should be profitable for the company’s suppliers of capital
It can be difficult to determine replacement costs – particularly for intangible assets
Deviations from the long-term historical average PE level can persist for extended periods
Trang 11Refer to Example 15 from the curriculum.
Refer to Example 16 from the curriculum
Refer to Example 17 from the curriculum
Summary
a explain the terms of the Cobb-Douglas production function and demonstrate how the function can be
used to model growth in real output under the assumption of constant returns to scale;
Assuming that the production function exhibits constant returns to scale:
Estimated percentage change in real GDP = % growth in total factor productivity + (output elasticity
of capital) x (% growth in capital stock) + (output elasticity of labor) x (% growth in labor input)
Increase in growth rate of total factor productivity, will increase the long-run real GDP growth
projection
Increase in rate of savings and investment will cause an increase the growth rate of the capital stock
(∆K/K) increase the long-run real GDP growth projection
Increase in growth rate of labor input will increase the long-run real GDP growth projection
b evaluate the relative importance of growth in total factor productivity, in capital stock, and in labor
input given relevant historical data;
Comparing China’s numbers to European Union’s numbers we can see that China has a higher growth
rate of GDP because all three factors: total factor productivity, capital stock and labor input are growing
at a faster rate as compared to Europe
c demonstrate the use of the Cobb-Douglas production function in obtaining a discounted dividend
model estimate of the intrinsic value of an equity market;
Trang 12 We can use the Gordon growth model to value a developed market equity index using the country’s
long-term trend growth rate V0=D0 (1+g)
gL = long-term growth rate
gS = short-term growth rate
N = number of years over which growth rate declines linearly from gS to gL
d critique the use of discounted dividend models and macroeconomic forecasts to estimate the intrinsic
value of an equity market;
Criticisms of using dividend discount models for estimating the intrinsic value of an equity market:
Quality of inputs Economic data may be unreliable
In economies experiencing structural changes, there may be extended periods during which
corporate earnings and dividends do not grow at the same rate as overall GDP
Extreme events such as hyperinflation and currency instability can occur, which will make the model
Compare relative value measures for each equity market to their historical values
Examine the trends in relative value measures for each equity market to identify market
momentum
Compare the expected returns for those equity markets expected to provide superior
performance to the expected returns for other asset classes, such as bonds, real estate, and
commodities
Industry analysis: Evaluate domestic and global economic cycles to determine those industries
expected to be top performers in the best-performing equity markets
Compare relative growth rates and expected profit margins across industries
Identify those industries that will be favorably impacted by expected trends in interest rates,
exchange rates, and inflation
Company analysis: Identify the best stocks in those industries that are expected to be
top-performers in the best-performing equity markets
Bottom-up approach:
Company analysis: Identify a rationale for why certain stocks should be expected to outperform,
without regard to the prevailing macroeconomic conditions
Identify reasons why a company’s products, technology, or services should be expected to be
successful
Evaluate the company’s management, history, business model, and growth prospects
Trang 13 Use discounted cash flow models to determine expected returns for individual securities
Industry analysis: Aggregate expected returns for stocks within an industry to identify the industries
that are expected to be the best performers
Market analysis: Aggregate expected industry returns to identify the expected returns for every
equity market
f discuss the strengths and limitations of relative valuation models;
g judge whether an equity market is under-, fairly, or over-valued using a relative equity valuation
P0 = Treasury bond yield
Equity market is undervalued
if earnings yield exceeds the
Ignores the equity risk premium
Compares a real variable to a nominal variable
Ignores earnings growth
Yardeni
model
E1
P0 = yB− d × LTEG
Equity market is undervalued
if earnings yield exceeds the
fair value estimate of the
earnings yield provided by the
Risk premium captured by the model is largely a default risk premium that does not accurately measure equity risk
The forecast for earnings growth may not be accurate or
Trang 14CAPE Real S&P 500 price index
divided by the moving
average of the preceding
10 years of real reported
earnings
Future equity returns will
be higher when cyclically
adjusted P/E ratio (CAPE)
is low
Controls for inflation and business cycle effects by using a 10-year moving average of real earnings
Historical data supports
an inverse relationship between CAPE and future equity returns
Changes in the accounting methods used to determine reported earnings may lead to comparison problems
Current period or other measures
of earnings may provide a better estimate for equity prices than the 10-year moving average of real earnings
Evidence suggests that both low and high levels of CAPE can persist for extended periods of time Tobin’s
R −DebtFuture equity returns will be
higher when Tobin’s q and
equity q are low
Both measures rely on
a comparison of security values to asset replacement costs (minus the debt market value, in the case of
equity q); economic
theory suggests this relationship is mean-reverting
Historical data supports
an inverse relationship between both
measures and future equity returns
It is difficult to obtain an accurate measure of replacement cost for many assets because liquid markets for these assets do not exist and intangible assets are often difficult to value
Evidence suggests that both low
and high levels of Tobin’s q and equity q can persist for extended
periods of time
Examples from the curriculum
Example 1 The Neoclassical Approach to Growth
1 The savings rate for a national economy is comparatively stable The economy faces a sharp
uptick in energy prices and at the same time imposes stringent restrictions on environmental
pollution The combined impact of energy and environmental factors renders a large portion of
the existing stock of manufacturing equipment and structures economically obsolescent What
is the impact on the economy according to Equation 3?
2 A country experiences a sharp demographic rise in the divorce rate and single-parent
households Using the framework of Equations 1 and 3, what is likely to happen to total national
production, total per capita income, and total income per household?
Solution to 1:
The sudden, unexpected obsolescence of a significant portion of the capital stock means that the
percentage growth rate in capital stock in that period will be negative, that is, ΔK/K < 0 All other things
being equal, this implies a one-time reduction in economic output Assuming no change in technological