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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 Is the aggregate stock market overvalued? Undervalued?

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Equity Valuation and Portfolio Management

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  1. 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)

  2. 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

  3. 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)

  4. 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

  5. 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

  6. 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

  7. Canadian Application

  8. Forecasting

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