Level III Review, Economic Concepts for Asset Valuation

Study session 7 in the Level III CFA Program curriculum covers two readings (19-20) in Economic Concepts for Asset Valuation in Portfolio Management.
Equity Market Valuation
By far the most important and testable of the two readings. The reading is a list of basic formulas to explain economic growth and market valuations. There are quite a few here but putting them on flash cards and drilling a few times should make it easy points.
Cobb-Douglas estimates the growth of total production through three factors: growth in capital, growth in labor, and growth in total factor productivity. The effect on the economy from growth in capital or labor is fairly easy to understand. The effect from total factor productivity is more difficult and often tested. The most likely scenario here is that a vignette in the essay section gives you a change and you must decide which factor it affects and whether it drives production up or down. Understand the the output elasticity of labor is just (1-output elasticity of capital) and be able to calculate the formula.
The H-Model is an intimidating formula and many candidates neglect it and ‘hope’ that it doesn’t show up on the exam (but it often does). It is easier if you reason through the pieces. The formula is really just the Gordon growth with a “compromise” estimate of growth based on the two periods. The estimate for growth is just the long-term rate plus half of the difference between the supernormal period and the long-term rate.
Understand the difference between the trailing P/E and the justified (forward) P/E. Trailing means the last four quarters while forward is of the forecasted four quarters, i.e. the ‘justified’ value of the shares based on estimates for earnings growth.
For the market valuation measures (Fed Model, Yardeni, etc.) understand how to compute and interpret the market’s valuation. The Fed Model says the S&P500 earnings yield (forward earnings/current price) should be equal to the 10-yr Treasury note when the market is fairly priced. The model ignores earnings growth which is corrected in the Yardeni Model. The Yardeni model uses the A-rated corporate bond yield but ignores the equity risk premium.
Tobin’s Q can be used for equity market valuation and physical capital investment. It is the market value of a company’s debt and equity divided by the replacement cost of assets. If the replacement cost of assets is greater (Tobin’s Q less than 1) then further investment is unprofitable. Substituting aggregate market values gives a model for market valuation.
The Equity Q Ratio is the company’s equity market cap divided by its net worth measured at replacement. Note that it is based on replacement cost and not price-to-book.
As with all readings, a big part of the material is understanding the strengths and limitations of the methods. Understand that relative valuations will not help if the whole market is over- or under-priced. Also, understand that the number of estimated inputs and accuracy of inputs can be a big limitation to the use of many methods (i.e. Gordon Growth and P/E)
Dreaming with BRICs
The reading seemed out of place to me when taking the Level III CFA Program exam back in 2011. You have already seen material on macroeconomic development and emerging economies, so the emphasis and forecasting on the BRICs seems unnecessary. The reading becomes even more outdated this year as we find out that, “BRICs” is no longer a widely-searched term on Google.
My own soapbox aside, there is some testable information here. Understand the effect of macro stability, institutional efficiency, openness, and education on economic growth. Also, understand the implication of convergence and exchange rates on economic growth. If you’ve done the previous readings on macroeconomics this should all be evident and not difficult to understand.
Study session eight covers two readings in asset allocation and is fairly conceptual. You have about 14 weeks left to the exam so you may want to assess where you are with a mock exam. This will help you modify your plans to be better prepared.
‘til next time, happy studyin’
Joseph Hogue, CFA

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