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Equity Valuation and Portfolio Management Individual stock valuation: covered in other finance courses Valuation of the market as a whole (16.6 in text) Active portfolio management (separate set of slides) B. Valuation of the Market Is the aggregate stock market overvalued? Undervalued?

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Equity valuation and portfolio management l.jpg
Equity Valuation and Portfolio Management

  • Individual stock valuation: covered in other finance courses

  • Valuation of the market as a whole (16.6 in text)

  • Active portfolio management (separate set of slides)


B valuation of the market l.jpg
B. Valuation of the Market

  • Is the aggregate stock market overvalued? Undervalued?

  • As with firm-level valuation, the two most important factors are:

    • Interest rate (related to discount rate)

    • Corporate news (related to cash flow, earnings, dividends)

  • At the market-level, corporate profits are strongly related to the macroeconomy, e.g., GDP forecasts


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Valuation of the Market (Cont’d)

Methodologies

  • Apply a PV model, e.g., DDM, to the aggregate market

    • Dividend data are available for the entire market. Can use, say, a constant growth model

  • The U.S. “Fed Model” popularized by Ed Yardeni

    • Simple comparison of the forward earnings yield (E1/P0) and 10-year Treasury yield (Y0)


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Application: S&P500

  • Method based on past relationship of the two variables

  • Intuition: if bonds have low yields, investors move to the stock market, thus driving stock prices up, and resulting in a low E1/P0


Application s p5005 l.jpg
Application: S&P500

  • If Y0 = E1/P0 : fair value

  • Numerical example:

    E1 = $54.09, Y0 = 4.5%. P0 = 1038 Hence, Y0 < E1/P0

    and the market is considered undervalued

  • If Y0 > E1/P0, market considered overvalued


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Application: S&P500

  • Model based on a comment by Alan Greenspan back in 1997

  • Model has never been sanctioned by the Federal Reserve, but is widely followed and referred to in the financial community




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