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Investments: Principles of Portfolio and Equity Analysis by Gerhard Van de Venter, CFA, Wendy L. Pirie, CFA, Jerald E. Pinto, CFA, Michael G. McMillan, CFA

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CHAPTER 11

EQUITY MARKET VALUATION

Peter C. Stimes, CFA

Altadena, CA, U.S.A.

Stephen E. Wilcox, CFA

Mankato, MN, U.S.A.

LEARNING OUTCOMES

After completing this chapter, you will be able to do the following:

  • Explain the terms of the Cobb-Douglas production function and demonstrate how the function can be used to model growth in real output under the assumption of constant returns to scale.
  • Evaluate the relative importance of growth in total factor productivity, in capital stock, and in labor input given relevant historical data.
  • Demonstrate the use of the Cobb-Douglas production function in obtaining a discounted dividend model estimate of the intrinsic value of an equity market.
  • Evaluate the sensitivity of equity market value estimates to changes in assumptions.
  • Contrast top-down and bottom-up forecasts of the earnings per share of an equity market index.
  • Explain and critique models of relative equity market valuation based on earnings and assets.
  • Judge whether an equity market is under-, fairly, or overvalued based on a relative equity valuation model.

1. INTRODUCTION

Economic strength or weakness affects equity prices through its effect on risk-free rates, risk premiums, and corporate earnings. These economic drivers of security prices are often considered fundamental because they will affect security returns throughout most investment horizons. It is widely accepted that equity prices are negatively related to risk-free rates and risk premiums and positively related to earnings ...

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