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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
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
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
valuation of the market cont d
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)
application s p500
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
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
application s p5006
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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