CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 r15 equity market valuation summary

Level III Equity Market Valuation Summary Graphs, charts, tables, examples, and figures are copyright 2016, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Cobb-Douglas Production Function Assuming that the production function exhibits constant returns to scale: Estimated percentage change in real GDP = % growth in total factor productivity + (output elasticity of capital) x (% growth in capital stock) + (output elasticity of labor) x (% growth in labor input) ΔY ΔA ΔK ΔL ≈ +∝ + (1 − ∝) Y A K L Y = Real GDP A = Total factor productivity K = Capital stock L = Labor α = Output elasticity of capital (1 – α) = Output elasticity of labor Increase in growth rate of total factor productivity  increase the long-run real GDP growth projection Increase in rate of savings and investment will cause an increase the growth rate of the capital stock (∆K/K)  increase the longrun real GDP growth projection Increase in growth rate of labor input  increase the long-run real GDP growth projection www.ift.world Intrinsic Value of an Equity Market D0 (1 + g) V0 = r−g V0 = D0 N + g L + (g s − g L r − gL D0 = current dividend r = discount rate gL = long-term growth rate gS = short-term growth rate N = number of years over which growth rate declines linearly from gS to gL Criticisms of using dividend discount models for estimating the intrinsic value of an equity market:  Quality of inputs Economic data may be unreliable  In economies experiencing structural changes, there may be extended periods during which corporate earnings and dividends not grow at the same rate as overall GDP  Extreme events such as hyperinflation and currency instability can occur www.ift.world T o p D o w n B o t T o m U p 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 • 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 bestperforming equity markets 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 www.ift.world Relative Value: Fed and Yardeni Models Model Fed model Formula and Predictions Strengths E1 = treasury bond yield P0 Easy to understand and apply Equity market is undervalued if earnings yield exceeds the yield on government securities E1 = yB − d × LTEG P0 Yardeni Equity market is undervalued if model earnings yield exceeds the fair value estimate of the earnings yield provided by the model Limitations Ignores the equity risk premium Compares a real variable to a nominal Consistent with discounted variable cash flow models that show an inverse relationship between Ignores earnings growth value and the discount rate Risk premium captured by the model is largely a default risk premium that does not accurately measure equity risk Improves on the Fed model by including: The forecast for earnings growth may not 1) the yield on risky debt and be accurate or sustainable 2) a measure of expected earnings growth as The estimate of fair value assumes the determinants of value discount factor investors apply to the earnings forecast remains constant over time www.ift.world Relative Value: CAPE Model Formula and Predictions Strengths Limitations CAPE Controls for inflation and business Real S&P 500 price index cycle effects by using a 10-year divided by the moving moving average of real earnings average of the preceding 10 years of real reported Historical data supports an inverse earnings relationship between CAPE and future equity returns Future equity returns will be higher when cyclically adjusted P/E ratio (CAPE) is low www.ift.world 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 Tobin’s Q Model Tobin’s q Formula and Predictions Tobin’s q = Debt+Equity AssetsR Equity R −Debt Strengths Limitations Both measures 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 meanreverting It is difficult to obtain an accurate measure of replacement cost for many assets because liquid markets for these assets not exist and intangible assets are often difficult to value and Equity q = Assets Equity q Future equity returns will Historical data supports an inverse be higher when Tobin’s q relationship between both and equity q are low measures and future equity returns www.ift.world Evidence suggests that both low and high levels of Tobin’s q and equity q can persist for extended periods of time ... o t T o m U p 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... their historical values • 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... P0 Easy to understand and apply Equity market is undervalued if earnings yield exceeds the yield on government securities E1 = yB − d × LTEG P0 Yardeni Equity market is undervalued if model earnings