CFA III SS 7 Economic Concepts for Asset Valutation

  1. Cobb Douglas Equation: Pure and Expected
    • Pure: Image Upload 1
    • Expected: Image Upload 2

    • 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
  2. Solow Residual
    Image Upload 3

    changes are all in percentage
  3. Short term vs long term changes in output
    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
  4. H model
    Image Upload 4
  5. Top down vs bottom up valuation general description
    • 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
  6. Use top down or bottom up?
    1. long-short market neutral
    2. allocation among markets or industries

    Pitfalls of each
    • 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
  7. Name the four relative value models
    • fed model
    • yardeni model
    • 10 year moving p/e model
    • q models
  8. Fed model definition; pros and cons
    • Image Upload 5
    • Earnings Yield = Image Upload 6

    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)
  9. Yardeni model definition; pros and cons
    • compare actual earnings Image Upload 7 to fair value earnings Image Upload 8 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
  10. 10 year average PE model definition; pros and cons
    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
  11. q model definition; pros and cons
    • Tobins q: Image Upload 9
    • Equity q: Image Upload 10
    • 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
Card Set
CFA III SS 7 Economic Concepts for Asset Valutation