Cobb-Douglas production function
Y = A * K^a * L^b
a + b = 1
Total economic output = Total factor productivity * Capital stock ^ output elasticity of Capital * Labor input ^ output elasticity of labor
K = eg Spending on raw materials
Economy Total Factor Productivity TFP can change over time due to
- changing technology
- changing restrictions on capital/labor flows
- changing trade restrictions
- changing laws
- changing division of labor
- Depleting/discovering of Natural Resources
H model
P = D0 / (r-gl) * ( ( 1+ gl ) + N / 2 * (gs-gl) )
Sustainable growth rate in GDP (based on Cobb Douglas production function) ===
Delta Y = Delta A + a * Delta K + (1-a) * Delta L
Delta A = Solow Residual
Relative value models
Fed model
Yardeni model
10yr MA price / earnings model
Fed model ratio =
= S&P yield / 10yr Treasury yield
=> if larger than 1 - equities are undervalued (or larger than long term average)
where S&P yield = Operating earnings / S&P value
Flaws of Fed model
- ignores equity risk premium
- ignores earnings growth for denominator
- compares real variable (S&P index) to nominal variable (Treasury yield)
Yardeni model =
Yardeni earnings yield = E1 / P0 = Yb - d ( LTEG )
Market undervalued if we have “>” instead of “=”
Yb = yield on A-rated corporate bonds (i.e. RFR + default premium) d = weighting factor for the importance of earnings growth = historically 0.10 LTEG = long term earnings growth
Things to remember about Yardeni model
- incorporates a proxy for equity market risk premium (yield of A-rated bonds)
- risk premium used is actually a measure of default risk - not a true measure of equity risk
- model relies on estimate of the value investors place on earnings growth (d), which is assumed to be constant over time
- LTEG assumptions might not be an accurate estimate of LT sustainable growth
10 yr MA P/E =
current market value / 10 year historical average of REAL earnings
Both denominator and numerator of historical ratio are adjusted to inflation (CPI) when are compared to current ratio
10 yr MA P/E … things to remember
- restating to CPI the impact of inflation is removed
- using 10 year - it captures the effects of business cycles
- doesn’t consider effects of changes in accounting rules/methods
- very high and low ratios have persisted historically - limiting usefulness in forming short term expectations
Tobin q model (asset based valuation model) - FORMULA and STRENGTHS / WEAKNESSES
= asset MV / asset replacement cost = ( MV of debt + MV of equity ) / asset replacement cost
Strength: easy to use (due to mean reversion) , demonstrated usefulness via negative correlation to equity return
Weakness: replacement costs difficult to estimate, deviations may persist
Equity q (asset based model) - FORMULA and STRENGTHS / WEAKNESSES
= equity MV / replacement value of net worth (net assets) = market cap / (replacement value of assets - liabilities )
Strength: easy to use (due to mean reversion) , demonstrated usefulness via negative correlation to equity return
Weakness: replacement costs difficult to estimate, deviations may persist
In top-down forecast, the analyst utilizes
macroeconomic factors to estimate performance of market wide indicators
In bottom-up forecast, the analyst first takes
micro-economic perspective by focusing on the fundamentals of individual firms
intrinsic price level of the index =
DIVIDEND * (1 + g) / ( r - g )
Solow residual
% change in total factor productivity
when both top down and bottom up approaches are recommended simultaneously
When approaching or leaving recessions, management expectations can be biased. It would be wise in these situations for the bottom-up analyst to also utilize a top-down approach to confirm earnings estimates.
- help analyst better understand market consensus
- reveal a gap that gives rise to significant market opportunities
1 example of investors using top-down approach
global macro hedge fund
2 example investors using bottom-up approach
market neutral strategies, alpha focus via stock selection
Aging a problem in what BRICs?
Russian and China
GDP per capita to remain below developed countries in all BRICs except
Russia
One third of US GDP growth to come from
Currency appreciation
BRICS with expected strongest tech progress
China Russia
