R17 Equity Valuation

Question 1

R17

Cobb-Douglas Production Function

Answer 1

• Assumes constants returns to scale
• Used to model growth in real GDP
• Neoclassical approach

ΔY/Y≈ ΔA/A+αΔK/K+(1−α)ΔL/L

• TFP aka. Solow residual
• TFP can grow over time based on:

1. Change in technology
2. Abolition of restrictions on the movement and ownership of capital and labor
3. Liberalization of trade policies
4. Dismantling of punitive taxation policies
5. Improvements in the division of labor

• Depletion and degradation of natural resources would detract from growth in TFP.

Question 2

R17

Economic impacts on C-B function

Answer 2

• Increase in saving rate >> people save more. Banks have more money to lend, will lower real interest rate. This will reduce cost of borrowing. Companies to make more capital investments - this leads to increase in capital stock.
• Increase in population growth >> Increases labour force participation rate and increases labour input therefore would increase real economic output of the country.

Question 3

R17

H Model

Answer 3

V₀ = D₀/r−g_L [(1+g_L) + N/2 (g_s−g_L)]

• Applied to equity market
• Developed markets long term growth is stable, but emerging market economies will not be as stable. Often experience a period of high growth that eventually becomes a more stable later period of lower growth.
• Use real values not nomimal because:

1. Real rates are more stable and easier to estimate
2. Inflation fluctuates over time and are different between countries.
3. C-B function estimates real economic output

Question 4

R17

Top Down

Answer 4

• Market 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 to identify those markets where equities are relatively cheap or expensive.

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.

Question 5

R17

Bottom Up

Answer 5

• 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.
• Market analysis: Aggregate expected industry returns to identify the expected returns for every equity market.

Question 7

R17

Fed Model

Relative Value Model

Answer 7

• Comparing to a 10 yr treasury yield
• The equity market is undervalued if its earnings yield exceeds the yield on government securities.
• It does suggest that equities become more attractive as an asset class when interest rates decline
• Easy to understand and apply.
• Consistent with discounted cash flow models that show an inverse relationship between value and the discount rate.

But:

• Ignores the equity risk premium.
• Compares a real variable to a nominal variable.
• Ignores earnings growth.

Question 8

R17

Yardeni Model

Relative Value Model

Answer 8

• E/P = Y_b - d x LTEG
• Y_b - single A rate corporate bond
• Equities are overvalued if the fair value estimate of the earnings yield provided by the model exceeds the actual earnings yield for the market index.
• Improves on the Fed model by including the yield on risky debt and a measure of expected earnings growth as determinants of value.
• Increases in y_B and decreases in d and LTEG produce higher fair value estimates of the earnings yield
• Decreases in y_B and increases in d and LTEG produce higher fair value estimates of the P/E ratio.

But:

• 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 earnings forecast remains constant over time

Question 9

R17

CAPE

Relative Valuation Model

Answer 9

• Future equity returns will be higher when 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.

But:

• 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.
• Not so good for short run expectations

Question 10

R17

Tobins Q

Answer 10

MV Equity + Debt / MV Replacement cost of assets

• Future equity returns will be higher when Tobin’s q is low.
• Rely on a comparison of security values to asset replacement costs, economic theory suggests this relationship is mean-reverting.
• Historical data supports an inverse relationship between both measures and future equity returns.

But:

• 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.

Question 11

R17

Equity Q

Answer 11

MV Equity / Assets - Liabilities [replacement value of equity]

• Future equity returns will be higher when equity q is low.
• 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.

But:

• 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 equity q can persist for extended periods of time.