CFA 2018 r15 equity market valuation

Level III Equity Market Valuation www.ift.world Graphs, charts, tables, examples, and figures are copyright 2014, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Introduction • Estimating a Justified P/E Ratio • Top-Down and Bottom Up Forecasting • Relative Value Models www.ift.world 2 Estimating a Justified P/E Ratio 2.1 Neoclassical Approach to Growth Accounting 2.2 The China Economic Experience 2.3 Quantifying China’s Future Economic Growth 2.4 Equity Market Valuation www.ift.world 2.1 Neoclassical Approach to Growth Accounting To estimate equity valuation we need to estimate earnings growth rate Assume earnings grow at the same rate as output (GDP) Growth rate of GDP can be estimated using the Cobb-Douglas function Y = A f(K, L) output elasticity = www.ift.world 2.2 The China Economic Experience www.ift.world www.ift.world 2.3 Quantifying China’s Future Economic Growth Estimating growth rates given elasticities, growth in TFP, growth in capital stock and growth in labor input www.ift.world 2.4 Equity Market Valuation • Translate macroeconomic forecasts into corporate cash flow forecasts • H-model • For emerging markets H-Model is useful: High initial growth which tapers down www.ift.world Example The S&P China BMI Index on 30 September 2009 is 358 Forecasted 12-month earnings per share for the composite are 18.00 RMB, and the current annual dividend rate for the composite is 7.90 RMB Assuming an 8.0 percent inflation-adjusted equity discount rate, a 30-year decline in dividend growth rates from an initial growth rate of 8.25 percent, and a terminal sustainable growth rate to perpetuity of 4.25 percent, compute the composite index price level implied by the H-Model Computed the justified p/e implied by such price level www.ift.world www.ift.world 10 Top-Down and Bottom-Up Forecasting Top Down www.ift.world 13 www.ift.world 14 Using Both Forecasting Types Example shows which forecasting approach is suitable for what situation At times can use both methods Bottom up method generally gives inflated estimates However, bottom up approach can help identify potential issues with ‘too big to fail’ financial institutions • Bottom up forecasts depend on consensus earnings estimates… hence more optimistic than top-down heading into a recession and more pessimistic when coming out • Read examples 5, and • • • • www.ift.world 15 Relative Value Models Model Description Fed Model Compare S&P500 forward earnings yield and 10-year Treasury yield Yardeni Model E1/P0 = yB - d x LTEG P/10-year MA (E) Tobin’s q and equity q www.ift.world 16 Fed Model: Compares S&P500 forward earnings yield and 10year Treasury yield Example 10 S&P 500 forward earnings yield is 5% and 10-year T-note yield is 4.6% Are stocks overvalued or undervalued? Equities undervalued! www.ift.world 17 Fed Model: Compares S&P500 forward earnings yield and 10-year Treasury yield www.ift.world 18 Yardeni Model E1/P0 = yB - d x LTEG yB is yield on A-Rated corporate bonds d is weighting factor measuring importance market assigns to earnings projections www.ift.world 19 Example 12 With d = 0.05, equities are overvalued www.ift.world 20 www.ift.world 21 Yardeni Model www.ift.world 22 P/10-year MA (E) 10 year moving average price earning ratio Example 13 www.ift.world 23 P/10-year MA (E) www.ift.world 24 Tobin’s q Tobin’s q = market value of company/ replacement cost of assets Equity q = market value of equity/ net worth of assets (based on replacement cost) www.ift.world 25 www.ift.world 26 Conclusion Estimating growth rates H-Model Dividend Discount Model Top-Down and Bottom Up Approaches Relative Value Approaches (Exhibit 17) Example and Practice Problems www.ift.world 27 ... Quantifying China’s Future Economic Growth 2.4 Equity Market Valuation www.ift.world 2.1 Neoclassical Approach to Growth Accounting To estimate equity valuation we need to estimate earnings growth... growth in labor input www.ift.world 2.4 Equity Market Valuation • Translate macroeconomic forecasts into corporate cash flow forecasts • H-model • For emerging markets H-Model is useful: High initial... P/10-year MA (E) www.ift.world 24 Tobin’s q Tobin’s q = market value of company/ replacement cost of assets Equity q = market value of equity/ net worth of assets (based on replacement cost)