1. Elizabeth Villeneuve is a senior economist at Proplus Financial Economic Consulting (Proplus). She is responsible for the valuation of equity markets in developing countries and is reviewing the preliminary report on Emerge Country prepared by one of her analyst, Danielle Delaroche. Emerge Country is now experiencing stronger economic growth than most develop countries.
Delaroche has summarized in Exhibit A some of the assumptions contained in the report. In modeling the growth in the country's real output, she has used the Cobb-Douglas production function under the assumption of constant returns to scale and, in valuing the equity market, she has used the standard Gordon growth model with constant dividend growth rate.
|
Exhibit A Assumptions for the Equity Index of Emerge Country
|
|
Annual dividend per share in 2008
|
450 CU*
|
|
Forecasted earnings per share in 2009
|
750 CU*
|
|
Forecasted annual growth in TFP
|
1.5%
|
|
Expected real growth rate of dividends to perpetuity
|
5.5%
|
|
Required real discount rate to perpetuity
|
7.5%
|
|
*CU = currency unit of Emerge Country
|
|
A. Based on the information in Exhibit A, calculate the equity index price level of Emerge Country implied by the Gordon growth model, as of 31 December 2008. Villeneuve is familiar with the Gordon growth model but not the H-model.
B. Identify two variables that are needed in the H-model and not needed in the Gordon growth model.
As an illustration of a relative value approach that can be used to support tactical asset allocation, Delaroche has estimated that the forward operating earnings yield of the equity index in Emerge Country is 6 percent and that the medium-term government bond yield is 7 percent. She then applies the Fed model to the situation in Emerge Country.
C. Based on the Fed model, determine whether the equity market is undervalued or overvalued and identify three criticisms of the Fed model.
Because most of Proplus's clients use strategies that require fundamental security analysis, proplus uses both top-down and bottom-up approaches in all reports dealing with equity return forecasts.
D. Contrast the two forecasting approaches used by Delaroche as they relate to industry analysis.