Market analysis: Examine valuations in different equity markets to identify those with superior expected returns.. • Examine the trends in relative value measures for each equity market
Trang 1Level III
Equity Market Valuation
Summary
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Trang 2Cobb-Douglas Production Function
ΔY
Y ≈
ΔA
A + ∝
ΔK
K + (1 − ∝)
ΔL L
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)
Y = Real GDP
A = Total factor productivity
K = Capital stock
L = Labor
α = Output elasticity of capital
(1 – α) = Output elasticity of labor
Increase in growth rate of total factor productivity 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 increase the long-run real GDP growth projection
Trang 3Intrinsic Value of an Equity Market
V0 = D0(1 + g)
D0
r − gL 1 + gL +
N
2 (gs − gL
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
D0 = current dividend
r = discount rate
gL = long-term growth rate
gS = short-term growth rate
N = number of years over which growth rate declines linearly from gS to gL
Trang 4Market analysis: Examine valuations in different equity markets to identify those with superior expected returns
• 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
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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
• 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
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Trang 5Model Formula and Predictions Strengths Limitations
Fed
model
E1
P0 = treasury bond yield
Equity market is undervalued if earnings yield exceeds the yield
on government securities
Easy to understand and apply
Consistent with discounted cash flow models that show an inverse relationship between value and the discount rate
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 model
Improves on the Fed model by including:
1) the yield on risky debt and 2) a measure of expected earnings growth as determinants of value
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 sustainable
The estimate of fair value assumes the discount factor investors apply to the
Relative Value: Fed and Yardeni Models
Trang 6Model Formula and Predictions Strengths Limitations
CAPE
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
Relative Value: CAPE
Trang 7Model Formula and Predictions Strengths Limitations
Tobin’s q
and
Equity q
Tobin’s q = Debt+Equity
AssetsR
Equity q = Equity
AssetsR−Debt
Future 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
Tobin’s Q