Equity Market Valuation

Question 1

Fundamentals

Answer 1

• Risk free rate, risk premium (-vely affected equity prices)
• Earnings growth (+vely affect equity prices)

Question 2

Growth Accounting

Answer 2

• used in economics to measure the contribution of different factors to economic growth
• Use of Cobb Douglas Production Function

Question 3

Basic Form - Cobb Douglas Production Function

Answer 3

"Y = AK(power of alpha)L(power of beta)"
Y= total real economic output 
A= Total factor productivity - that part of Y not accounted by capital and labour. 
K= Capital Stock 
alpha=output elasticity 
L= labour input 
Beta = output elasticity for L

Question 4

Assuming that production functions exhibit constant returns to scale

Answer 4

Δ Y/ Y ≈ Δ A/A + α Δ K/K + (1 − α ) Δ L/L

Percentage growth in real output (GDP)

Question 5

Total factor productivity (TFP)

Answer 5

• Also referred as Solow residual
• Often linked to technology and increase in TF indicates faster increase in GDP
• TFP also affected by major changes in the economy - political or regulatory structure

Question 6

Growth rate - corporate earning

Answer 6

• Should bear close relationship with GDP after adjusting for Inflation

Question 7

H Model - Growth rate pattern

Answer 7

dividend growth rates are expected to decline in a linear fashion over a finite period and then sustainable growth rate from the end of that horizon to perpetuity

Question 8

H Model - Value

Answer 8

V = D(0)/r-g(l) [(1+g(l)+ N/2 (g(s)-g(l)]

Question 9

Forward (justified) P/E Ratio

Answer 9

estimated intrinsic value/year ahead expected earnings

Question 10

Criticism of Macroeconomic Forecasts/Dividend model

Answer 10

• Quality of input data
• Developing markets - obtaining accurate and timely data is difficult
• Companies not necessarily track GDP growth rate
• Hyperinflation, currency instability, and other disequilibria - confidence in the model diminishes due the factors mentioned

Question 11

Top down approach

Answer 11

Macroeconomic projections -> return expectations of large stock markets -> return expectations of large market sectors and industry groups -> returns of individual securities

Question 12

Bottom Up Approach

Answer 12

Microeconomic outlook for individual companies ->aggregate into industry groupings, sectors ->equity market as whole

Question 13

Portfolio Suitability for each type of forecasting

Answer 13

Not necessary to carry out the whole analysis

can be limited to the step where necessary

Question 14

Contrast

Answer 14

Bottom up/Top down
Consesus earnings estimate from equity research analyst/econometric methods
More optimistic heading into recession
More pessimitic heading out of recession
/Prefer to TD approach when company’s react slowly to changes in the economy
/TD rely on past trends and data - hence not necessairly accurate
BU approach preferred when the economy is on brink of change.

Question 15

Earnings Based Models - Fed Model

Answer 15

US stocks are undervalued if the earnings of SP500 is greater than yield on US treasury bonds and vice versa
Criticism:
Ignores risk premium
Ignores inflation and earnings growth opportunity
Compares real variable earnings yield to nominal variable Tbond yield

Question 16

Gordon Growth Model

Answer 16

v=d/r-g
Forward earnings yield based on Gordon Growth Model
E/P=r-ROE(1-p)/p where p=payout ratio

Question 17

Yardeni Model

Answer 17

Assumes investors value earnings than dividends
E/P=r-g
E/P=y(b)-d*LTEG
d=weighting factor measuring the importance people give to earnings projections
Interpretation:
Justified earning yield is greater than market implied then it overvalued, less than then its undervalued
-Captures the default risk premium by using the corporate bond yield
Criticism
-Does not fully capture equity risk premium

Question 18

10 year moving average

Answer 18

=real S&P500 price index/moving avg of previous 10 years of proceeding real reported earnings
- Control the business cycle effects

Question 19

Asset based models - Tobin’s q ratio

Answer 19

Company Level:
Market value of company/replacement cost of assets
Interpretation: >1 values company’s assets more and hence profitable and vice versa if the result is less than 1
Market Level:
Equity and debt values of the market/aggregate corporate assets
Criticism:
- Difficult to obtain replacement cost of assets

Question 20

Equity’s q ratio

Answer 20

Equity market capitalisation/net worth measured at replacement cost