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Investments - Chapter11 Equity Market Valuation

This document provides an overview of equity market valuation using the neoclassical approach to growth accounting and various valuation models. It discusses: 1) The Cobb-Douglas production function and the growth accounting formula that relates changes in output to changes in total factor productivity, capital stock, and labor. 2) How total factor productivity is influenced by technical progress, innovation, and improvements to political/regulatory structures and the division of labor. 3) Growth rates for real GDP, total factor productivity, capital stock, and labor input for China, the Soviet Union, US, and EU over different time periods. 4) Forecasts for China's economic growth through 2030 based on assumptions about total

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84 views28 pages

Investments - Chapter11 Equity Market Valuation

This document provides an overview of equity market valuation using the neoclassical approach to growth accounting and various valuation models. It discusses: 1) The Cobb-Douglas production function and the growth accounting formula that relates changes in output to changes in total factor productivity, capital stock, and labor. 2) How total factor productivity is influenced by technical progress, innovation, and improvements to political/regulatory structures and the division of labor. 3) Growth rates for real GDP, total factor productivity, capital stock, and labor input for China, the Soviet Union, US, and EU over different time periods. 4) Forecasts for China's economic growth through 2030 based on assumptions about total

Uploaded by

makoto-san
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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CHAPTER 11

EQUITY MARKET VALUATION


Presenter
Venue
Date
NEOCLASSICAL APPROACH TO GROWTH
ACCOUNTING
Cobb-Douglas production function

α β Assuming constant returns to scale, 1 – α = β, and


Y = AK L taking the natural logarithm of both sides of first
equation gives

ln(Y ) = ln( A ) + α ln( K ) + (1 − α ) ln( L )


Taking first differences of second equation and
using a property of logarithms results in this
approximation:
∆Y ∆A ∆K ∆L
≈ +α + (1 − α )
Y A K L
GROWTH ACCOUNTING FORMULA
• Percentage growth in real output
ΔY/Y (GDP)
• Percentage growth in total factor
ΔA/A productivity
• Percentage growth in the capital
ΔK/K stock
• Percentage growth in labor
ΔL/L
• Output elasticity of capital
α
• Output elasticity of labor
1−α
∆Y ∆A ∆K ∆L
≈ +α + (1−α)
Y A K L
TOTAL FACTOR PRODUCTIVITY (TFP)

Changes in
Political/Regulatory
Structures

Technical Improvements in
Progress and the Division of
Innovation Labor

TFP
THE CHINA ECONOMIC EXPERIENCE

Real GDP Growth in total Growth in Growth in


growth factor productivity capital stock labor input
Countries Time Period ∆Y/Y ∆A/A ∆K/K ∆L/L
China 1978–1995 10.11% 3.80% 9.12% 3.49%
1995–2007 9.25% 1.45% 12.81% 2.78%
Soviet Union 1950–1970 5.4% 1.6% 8.8% 1.8%
1970–1985 2.7% –0.4% 7.0% 1.1%
United States 1950–1972 3.9% 1.6% 2.6% 1.4%
1972–1996 3.3% 0.6% 3.1% 1.7%
1996–2004 3.6% 1.5% 2.6% 0.7%
European Union 1960–1973 5.1% 3.2% -- 4.8%
1973–2003 2.2% 1.0% 0.5% 2.8%

Source: Zheng, Hu, and Bigsten (2009). China’s output elasticity for
capital (α) and output elasticity for labor (1 – α) were both estimated to be
0.5.
QUANTIFYING CHINA’S FUTURE ECONOMIC
GROWTH

ΔA/A ΔK/K ΔL/L


• Reform • Government • Population
measures? policies? growth?
• Productivity? • Price • Labor force
controls? participation
• High savings rates?
rates?
EXHIBIT 11-2 GROWTH PROJECTIONS
(2009−2030)

Growth in total Output Output


Real GDP factor elasticity of Growth in elasticity of Growth in
growth, productivity, capital, capital stock, labor, labor input,
Country ∆Y/Y ∆A/A α ∆K/K 1-α ∆L/L
China 8.0% 2.5% 0.5 8.0% 0.5 3.0%
United States 2.75% 1.2% 0.3 4.0% 0.7 0.5%
European Union 2.2% 1.0% 0.4 3.0% 0.6 0.0%
Source: Zheng, Hu, and Bigsten (2009).
GROWTH FORECAST FOR CHINA

Total factor productivity + Growth in capital stock


+ Labor force growth = Real GDP growth

Near-term growth forecast: 2.5% + (0.5 × 12%) +


(0.5 × 1.5%) = 9.25%

Sustainable economic growth rate: 1.25% + (0.5


× 6%) + (0.5 × 0.0%) = 4.25%
EQUITY MARKET VALUATION

Corporate Discounted
Macroeconomic
Cash Flow Cash Flow
Justified
Forecasts
Forecasts Model P/E
USING THE H-MODEL TO ESTIMATE A
JUSTIFIED P/E

The H-model:
D0  N 
V0 =  (1 + g L ) + ( g S − g L )
r − gL  2 
Assumptions:
• Dividend growth declines linearly from rate gS to rate gL
over N years.
• After N years, dividends grow at rate gL into perpetuity.

H-model estimate of intrinsic value


Justified P/E =
Year-ahead expected earnings
EXHIBIT 11-3 JUSTIFIED P/E RATIOS FOR
CHINESE EQUITY MARKET AT MID-YEAR 2009

Terminal Real Real Equity Discount Rate


Growth Rate 6.00% 6.50% 7.00% 7.50% 8.00% 8.50% 9.00% 9.50%
3% 26.8 23.0 20.1 17.9 16.1 14.6 13.4 12.4
4% 37.3 29.9 24.9 21.3 18.7 16.6 14.9 13.6
5% 69.0 46.0 34.5 27.6 23.0 19.7 17.2 15.3
Note: Chinese equity market justified P/Es: 30-year transition from
9.25% real dividend growth to various terminal growth rates to
perpetuity.
EXHIBIT 11-6 RETURN AND VOLATILITY DATA,
31 DECEMBER 2001–31 DECEMBER 2008

S&P China BMI MSCI China S&P 500


Annualized nominal total return (1) 14.7% 16.6% –1.5%
Annualized standard deviation of total returns (2) 29.4% 29.4% 14.3%
Annualized inflation rate (3) 3.7% 3.7% 2.6%
Notes:
(1) In RMB for Chinese composites, USD for S&P 500
(2) Based on monthly observations
(3) Data through 2007, reflect changes in GDP deflator
Sources for data: Standard & Poor’s, Morgan Stanley, Bloomberg, World Bank.

U.S. real equity Chinese real


discount rate = equity discount
6−7%? rate = 7.5−8.5%?
TOP-DOWN AND BOTTOM-UP
FORECASTING

Forecast Forecast Forecast


Macroeconomic
Market Industry Security
Projections
Returns Returns Returns

Forecast Forecast Forecast


Microeconomic
Security Industry Market
Projections
Returns Returns Returns
TYPICAL APPROACH TO TOP-DOWN
ANALYSIS
Market Analysis
Examine valuations in different equity markets to identify those with
superior expected returns.

Industry Analysis
Evaluate domestic and global economic cycles to determine those industries
expected to be top performers in the best-performing equity markets.

Company Analysis
Identify the best stocks in those industries that are expected to be top
performers in the best-performing equity markets.
TYPICAL APPROACH TO BOTTOM-UP
ANALYSIS
Company Analysis
Identify a rationale for why certain stocks should be expected to
outperform, without regard to the prevailing macroeconomic conditions.

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.
EXHIBIT 11-8 STANDARD AND POOR’S
FORECASTS, JULY 2009

Quarter Ending Operating Earnings per Share Operating Earnings per Share Difference
(estimates are bottom-up) (estimates are top-down)
31 Dec 2010 $20.39 $12.50 $7.89
30 Sep 2010 19.11 11.42 7.69
30 Jun 2010 18.00 11.18 6.82
31 Mar 2010 16.59 10.86 5.73
31 Dec 2009 16.25 11.72 4.53
30 Sep 2009 15.05 11.68 3.37
30 Jun 2009 14.06 11.05 3.01
RELATIVE VALUE MODELS

Relative
Value
Models

Earnings- Asset-
Based Based

Fed Yardeni P/10-Year


Tobin’s q Equity q
Model Model MA(E)
FED MODEL

Predictions of the model:


• Stocks are undervalued if their forward earnings yield is
greater than the yield on government bonds.
• Stocks are overvalued if their forward earnings yield is less
than the yield on government bonds.
Limitations:
• Ignores the equity risk premium.
• Compares a real variable with a nominal variable.
• Ignores earnings growth.
EXHIBIT 11-10 THE FED MODEL: DIFFERENCE BETWEEN THE
S&P 500 FORWARD EARNINGS YIELD AND YIELD ON 10-
YEAR T-NOTES (MONTHLY DATA: JANUARY 1979–DECEMBER
2008)

Source for data: www.yardeni.com.


YARDENI MODEL
Moody’s A-rated corporate bond Consensus five-year earnings
yield growth forecast for the S&P 500

E1
= y B − d × LTEG
P0
Weighting factor measuring the importance the market assigns to
the earnings projections (average is about 0.10)
Concerns:
1) The risk premium captured by the model is largely a default risk premium
and not the future equity risk premium, which is unobservable.
2) The consensus five-year earnings growth forecast for the S&P 500 from
Thomson Financial may not be sustainable.
3) Evidence suggests that the weighting factor varies significantly over time.
EXHIBIT 11-12 OVERVALUATION (+) AND UNDERVALUATION
(−) OF S&P 500 INDEX VS. FAIR VALUE ESTIMATE USING
YARDENI MODEL WITH D = 0.10
(MONTHLY DATA: JANUARY 1985–DECEMBER 2008)
P/10-YEAR MA(E)
Campbell and Shiller’s (1998, 2005) 10-year Moving
Average Price/Earnings [P/10-year MA(E)] has become a
popular measure of market valuation:
• Numerator of P/10-year MA(E) is the real S&P 500 price
index.
• Denominator is the moving average of the preceding 10
years of real reported earnings.
• Stock index and earnings are adjusted for inflation using
the Consumer Price Index (CPI).
• Purpose of the 10-year moving average of real reported
earnings is to control for business cycle effects on
earnings.
EXHIBIT 11-15 P/10-YEAR MA(E) AND
PREDICTED 10-YEAR REAL PRICE GROWTH
P/10-YEAR MA(E): ADVANTAGES AND
DISADVANTAGES
Advantages
• Controls for inflation
• Controls for business cycle effects
• Evidence supports a negative
relationship with future equity
returns

Disadvantages
• Changes in accounting methods
may lead to comparison problems
• Current period data may provide
better estimates of value
• Evidence suggests high and low
levels can persist for long time
periods
ASSET-BASED MODELS: TOBIN’S q AND
EQUITY q
Assets at Market Value or Market Value of Equities
Replacement Cost Liabilities Outstanding
28,277.33 12,887.51 9,554.05
Data source: www.federalreserve.gov/releases/z1/.
Fourth quarter 2008

Tobin’s q = Market value of a company ÷ Replacement cost


of assets = (12,887.51 + 9554.05) ÷ 28,277.33 = 0.79

Equity q = Equity market capitalization ÷ Net worth


measured at replacement cost = 9,554.05 ÷ (28,277.33 –
12,887.51) = 0.62
EXHIBIT 11-16 EQUITY q AND TOBIN’S q
QUARTERLY DATA: 1952 Q1–2008 Q4

Data source: www.federalreserve.gov/releases/z1/.


TOBIN’S q AND EQUITY q:
ADVANTAGES AND DISADVANTAGES
Advantages:
• Rely on a comparison of security
values with asset replacement costs
and theory suggests the relationship
is mean-reverting
• Evidence supports a negative
relationship with future equity
returns

Disadvantages:
• Difficult to accurately measure
replacement cost for many assets
• Evidence suggests high and low
levels can persist for long time
periods
SUMMARY

• Cobb-Douglas production function


• Growth accounting formula
• Total factor productivity, capital stock, labor input
• H-model estimate of equity market value
• Top-down and bottom-up analysis
• Earnings-based equity market valuation models
• Asset-based equity market valuation models

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