CFA CFA level 3 CFA level 3 CFA level 3 CFA level 3 CFA level 3 CFA level 3 finquiz item set answers, study session 7, reading 15

Question ID: 11922 Correct Answer: A The top-down model for economic valuation uses macroeconomic projections to produce return expectations for large stock market composites.. If desi

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FinQuiz.com

CFA Level III Item-set - Solution

Study Session 7 June 2018

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FinQuiz Level III 2018 – Item-sets Solution

Reading 15: Equity Market Valuation

1 Question ID: 11920

Correct Answer: B

The Cobb-Douglas model calculates real GDP growth as follows:

∆ܻ

ܻ =

∆ܣ

ܣ +ܽ

∆ܭ

ܭ +ሺ1 − ܽሻ∆ܮ

ܮ

∆ܻ

ܻ = 1.0% +ሺ0.7ሻሺ2.5%ሻ + ሺ0.3ሻሺ0.0%ሻ = 2.75%

Correct Answer: B

The Gordon growth model states that

( )

g r

g D

V

−

+

= 0 1

0

This can be rearranged as follows:

( )

g V

g D

r = + +

0

0 1

% 843366

10

% 4 3 545

,

1

115

= +

=

Correct Answer: A

The top-down model for economic valuation uses macroeconomic projections to produce return expectations for large stock market composites These can be further broken down into forecasts for various market sectors and industry groups within the composites

The bottom-down analysis begins with the microeconomic outlook for the fundamentals of individual companies If desired, the forecasts for individual security returns can be aggregated into expected returns for industry groupings, market sectors and for the equity market as a whole

Recommendation 1:

One of the problems cited with the bottom-up approach is that it may be influenced by overly

optimistic corporate forecasts produced by the managers working for those corporations Since analysts tend to alter their forecasts following the announcement by corporate managers, their

forecasts may be subject to the same overoptimistic bias managerial forecasts fall victim to Such is not the case with the top-down approach, which takes a macroeconomic approach when developing expected return forecasts Thus recommendation 1 accurately characterizes the difference between the two approaches in this respect

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Recommendation 2:

The top-down approach takes into account macro-economic global and local factors to develop economic forecasts Thus a top-down approach will be preferred to the bottom-up approach when evaluating the effects of movements in the Japanese exchange rates on the expected returns of

Japanese exporter’s stocks The top-down analysis will identify the markets and then subsequently the industries, which are likely to be top-performers in the best-performing equity markets (and benefit)

as a result of Japanese exchange rate movements The analyst will then identify the best stocks in those industries that are expected to be top-performers in the best-performing equity markets

However recommendation 2 has inaccurately suggested that the bottom-up analysis will be useful in this situation

Correct Answer: C

In order to value U.S corporate securities the model Webber will most likely choose is the P/10-year

MA (E) This is because this model:

accurately captures the riskiness of equity securities by capturing the effects of business cycle changes on a security’s expected returns However, the Fed model completely ignores equity risk premiums whereas the Yardeni model captures default risk premium thus failing to accurately account for equity risk

accounts for changes in the level of the inflation index when determining the value of the real stock price index and real earnings Thus it accounts for inflation in both the numerator and denominator The Fed model compares a real variable (earnings yield) to a nominal variable (T-bond yield) Thus the latter model does not fully account for the effects of inflation on security price returns

The Fed model ignores earnings growth whereas the Yardeni model’s estimates of fair value assume that the discount factor investors apply to earnings remains constant In this way, either of the two models do not allow for changes in the values of input variables and thus fail to meet the criteria specified by Webber

Correct Answer: C

The Yardeni model is stated as follows:

LTEG d

r

P0 = − ×

(0.40) 13.45% 3.12%

% 50

=

xstocks

GermanInde

P

Thus German index stocks are undervalued as 3.12% < 4.00%

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Correct Answer: A

Tobin’s equity q = Market value of equities outstanding ÷ replacement cost of assets – liabilities Tobin’s equity q U.S Market = $25,837 ÷ ($45,259 – $30,234)

≈ 1.72

Relative to the long-term equity q average of 1.00, the U.S equity market appears to be overvalued as the equity q for the market is greater than the long-term equity q average (1.72 > 1)

Additionally, a greater than 1 equity q value for the U.S market implies the denominator (market value of assets – liabilities) is too low which implies the replacement cost of assets are understated

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