EQUITY MARKET VALUATION

Question 1

17.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.

Answer 1

CD uses the country’s labor input and capital
stock to estimate the total real economic output.

Question 2

LOS 17.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.
LOS 17.d: Critique the use of discounted dividend models and macroeconomic
forecasts to estimate the intrinsic value of an equity market.

Answer 2

Cobb-Douglas provides a macroeconomic forecast of the growth rate for the underlying economy and this is the base for estimating cash flow and dividend growth rates for
dividend discount models (DDM).

Question 3

17.f: Discuss the strengths and limitations of relative valuation models.
LOS 17.g: Judge whether an equity market is under-, fairly, or over-valued using a relative equity valuation model.

Answer 3

The Fed model assumes that the expected operating earnings yield on the S&P 500
(i.e., expected aggregate operating earnings divided by the current index level) should be
the same as the yield on long-term U.S. Treasuries: .

The Yardeni model for estimating the equilibrium earnings yield (i.e., the fair earnings
yield) is based on a variation of the constant growth dividend discount model (CGM),
in which investors value total earnings rather than dividends:

Tobin’s q compares the current market value of a company to the replacement cost of its
assets.

The equity q It compares the aggregate market value of
the firm’s equity to the replacement value of the firm’s net worth