Reading 16 Equity Market Valuation Flashcards
Growth accounting
Growth accounting is used in economics to:
- measure the contribution of different factors—usually broadly defined as capital and labor—to economic growth and,
- indirectly, to compute the rate of an economy’s technological progress.
The neoclassical approach to growth accounting uses the Cobb-Douglas production function.
Cobb-Douglas production function
The basic form of the Cobb-Douglas production function is set forth as Equation (1), where Y represents total real economic output, A is total factor productivity, K is capital stock, α is output elasticity of K, L is labor input, and β is the output elasticity of L. Total factor productivity (TFP) is a variable which accounts for that part of Y not directly accounted for by the levels of the production factors (K and L).
Y = AKαLβ (1)
If we assume that the production function exhibits constant returns to scale (i.e., a given percentage increase in capital stock and labor input results in an equal percentage increase in output), we can substitute β = (1 − α) into Equation 1.
ΔY/Y≈ΔA/A+αΔK/K+(1−α)ΔL/L (2)
growth in TFP is determined using the other inputs as noted by Equation (2) and is commonly referred to as the Solow residual.
TFP
- Interpreting TFP as a measure of the level of technology, growth in TFP is often described as a measure of “technical progress” and linked to innovation.
- However, growth in TFP, as a residual in the sense described, can be driven by factors other than improvements in technology. These factors could be particularly significant in economies that are experiencing major changes in political and/or regulatory structures. As examples, liberalization of trade policies, abolition of restrictions on the movement and ownership of capital and labor, the establishment of peace and the predictable rule of law, and even the dismantling of punitive taxation policies would be expected to contribute to growth in TFP.
- Finally, growth in TFP can benefit from improvements in the division of labor that arise from the growth of the economy itself. By contrast, developments such as the depletion and degradation of natural resources would detract from growth in TFP.
H-model
H-model, in which dividend growth rates are expected to decline in a linear fashion, over a finite horizon, towards an ultimately sustainable rate from the end of that horizon into perpetuity.
V0=D0/(r−gL)*[(1+gL)+N/2(g<span>s</span>−gL)]
The justified P/E
The (forward) justified P/E is the estimated intrinsic value divided by year-ahead expected earnings.
Criticisms of Equity Market Valuation Using Dividend Discount Models
- The possible criticisms of our approach should not be overlooked.
- From a practical perspective, there may be severe problems with the accuracy of data inputs. It is difficult enough to obtain macroeconomic data in developed countries with long-established methods and facilities. In developing markets or in economies experiencing profound governmental and structural change, such as the Eastern Bloc after the fall of the Berlin Wall, the problems of obtaining accurate and, more importantly, historically consistent, data are multiplied.
- The same fluidity in political and demographic fundamentals also calls into question whether companies’ growth rates will track GDP growth rates. In certain instances, there can be long departures between growth rates, meaning that for long periods of time the share of corporate profits may be rising or declining relative to GDP.
Top-Down and Bottom-Up Forecasting
In top-down forecasting, analysts use macroeconomic projections to produce return expectations for large stock market composites, such as the S&P 500, the Nikkei 225, or the FTSE 100. These can then be further refined into return expectations for various market sectors and industry groups within the composites. At the final stage, such information can, if desired, be distilled into projected returns for individual securities.
Bottom-up forecasting begins with the microeconomic outlook for the fundamentals of individual companies. An analyst can use this information to develop predicted investment returns for each security. 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.
Top-Down Analsis
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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.
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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.
Bottom-Up Analysis
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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.
- Market analysis: Aggregate expected industry returns to identify the expected returns for every equity market.
Using Both Forecasting Types
It is frequently the case that top-down and bottom-up forecasts provide significantly different results. In such instances, the analyst should investigate the underlying data, assumptions, and forecast methods before employing them as a basis for investment decisions. After all, if forecasts cannot be consistent with each other, at least one of them cannot be consistent with underlying reality. Reconciling top-down and bottom-up forecasts is therefore a discipline that can help prevent us from taking inappropriate investment actions.
In rare and significant instances, we will find that carefully retracing the steps reveals a gap between the two forecast types that gives rise to significant market opportunities. In such instances, the process of reconciling the two types of forecasts creates instances where we differ significantly and correctly from the consensus.
Comparing and Evaluating Top-Down and Bottom-Up Forecasts
There are several possible reasons for the forecast discrepancies.
- First, the bottom-up estimates may be influenced by managers believing that their own company’s earnings prospects are better than those for the economy as a whole.
- Alternatively, the bottom-up estimates may be correctly detecting signs of a cyclical economic and profit upturn. Most top-down models are of the econometric type and rely on historical relationships to be the basis for assumptions about the future. Thus, top-down models can be slow in detecting cyclical turns.
- If the belief exists that companies are reacting slowly to changes in economic conditions, then a market analyst may prefer a top-down forecast.
- However, top-down earnings forecasting models also have limitations. Most such models rely on the extrapolation of past trends in economic data. As a result, the impact of a significant contemporaneous change in a key economic variable or variables on the stock market may not be accurately predicted by the model.
- Also, the models may be incorrectly specified since the variables used in the past may no longer be appropriate.
The Fed model
The Fed model is a theory of equity valuation that hypothesizes that the yield on long-term US Treasury securities (usually defined as the 10-year T-note yield) should be equal to the S&P 500 earnings yield (usually defined as forward operating earnings divided by the index level) in equilibrium. Differences in these yields identify an overpriced or underpriced equity market. The model predicts:
- US stocks are undervalued if the forward earnings yield on the S&P 500 is greater than the yield on US Treasury bonds.
- US stocks are overvalued if the forward earnings yield on the S&P 500 is less than the yield on US Treasury bonds.
For example, if the S&P 500 forward earnings yield is 5 percent and the 10-year T-note yield is 4.5 percent, stocks would be considered undervalued according to the Fed model.
Criticisms of the Fed model
- The key criticism of the Fed model is that it ignores the equity risk premium. (Informally, the equity risk premium is the compensation demanded by investors for the greater risk of investing in equities compared to investing in default-risk-free debt.)
- Thus, implicit in the Fed model equilibrium are the assumptions that the required return, r, and the accounting rate of return on equity, ROE, for risky equity securities are equal to the Treasury bond yield, yT.
- Two additional criticisms of the Fed model are that it ignores inflation and earnings growth opportunities.
- Another criticism of the Fed model is that it ignores any earnings growth opportunities available to equity holders beyond those forecasted for the next year (as reflected by expected earnings, E1).
- In spite of the several criticisms, the Fed model still can provide some useful insights. It does suggest that equities become more attractive as an asset class when interest rates decline.
- Some analysts find a comparison of the earnings yield and Treasury bond yield to be most useful when the relationship is towards the extremes of its typical range.
- The forward earnings yield measure used in the Fed model to assess the worth of equities fails to accurately capture the long-term growth opportunities available to equity investors.
Yardeni model
- The Yardeni model addresses some of the criticisms of the Fed model. In creating the model,Yardeni (2002) assumed investors valued earnings rather than dividends.
- As a data input for the required return, r, Yardeni used the Moody’s A-rated corporate bond yield,yB, which allowed for risk to be incorporated into the model.
- As an input for the growth rate, g, Yardeni used the consensus five-year earnings growth forecast for the S&P 500 from Thomson Financial, LTEG (Long-term earning growth).
- The Yardeni model introduces an additional variable, the coefficient d. It represents a weighting factor measuring the importance the market assigns to the earnings projections. Yardeni (2000)found that the historical values for d averaged about 0.10. However, depending on market conditions, d can vary considerably from its historical average. Equation below presents the Yardeni model stated as the justified (forward) earnings yield on equities.
E1/P0=yB−d×LTEG
! E1 is forward earnings !
P/10-year MA(E)
10-year Moving Average Price/Earnings [P/10-year MA(E)] has become a popular measure of market valuation. The authors defined the numerator of P/10-year MA(E) as the real S&P 500 price index and the denominator as the moving average of the preceding 10 years of real reported earnings.
The goal of averaging the earnings is to normalize earnings by providing an estimate of what earnings would be under mid-cyclical conditions. The implicit assumption is that the typical business cycle lasts 10 years.
