CFA III SS 7 Economic Concepts for Asset Valutation

• Pure: 
• Expected:

• Y = total economic output
• A = total factor productivity
• K = capital stock
• L = labor input
• alpha = output elasticity of K
• beta = output elasticity of L (1-alpha)

changes are all in percentage

changes are all in percentage

ex. one time costs incurred to meet increased environmental restrictions will only have a short term effect

ex. changes such as new, permanent import restrictions would have a long term effect

• top down: analyst uses macro factors to estimate market-wide indicators
• successive steps would be to identify sectors that will outperform; may go down to individual stocks
• bottom up: analyst takes micro perspective by analyzing individual stocks; assesses firms willingness/ability to adopt tech necessary to grow firm; may use CF analysis

• 1. bottom up
• 2. top down

• top down: models generally based on historical relationships and slow to reflect changes
• bottom up: analysts are overly emotional and optimistic about companies they cover; also, overly optimistic in expansion and overly pessimistic in recession

• fed model
• yardeni model
• 10 year moving p/e model
• q models

• 
• Earnings Yield = 

Ratio > 1 => market is undervalued

Pros: easy; consistent with CF analysis - higher discount rates (treasury yields) should result in lower stock values

Cons: no equity risk premium; ignores growth; compares a real value (s&p) to a nominal value (treasury)

• compare actual earnings  to fair value earnings  where
• Yb = yield on A rated corporate bonds
• d = adjustment factor for how analysts value growth (historically 0.1)

LTEG = long term (5 year) earnings growth forecast

actual < fair => market is overvalued

Pros: as compared to fed model, incorporates some equity risk using A rated corp bonds; includes earnings growth

Cons: true equity risk premiums are higher than A rated bonds; earnings estimate can be wrong; assumes constant discount rate; d is a "fudge factor," though there is some correlation to the cycle the market is in

current P/E > 10 year MA P/E => overvalued

inflation adjusted to make market prices comparable

Pros: removes effect of business cycle and inflation

Cons: accounting changes can make comparison inappropriate; periods of high or low P/Es can persist for long periods of time

• Tobins q: 
• Equity q: 
• q > 1 => overvalued

Pros: supported by economic theory and evidence that in the long run values should equal cost

Cons: Estimating replacement value is difficult; divergence from 1.0 can persist for long periods of time