Equity Market Valuations
LAPERS Fall Seminar
September 17, 2013
Presentation by
Dr. Bhaskaran Swaminathan, PhD
Partner and Director, Research
LSV Asset Management
Agenda
Motivation
 Popular valuation measures
 An intrinsic value based approach
 Predicting Market Returns
 Implications and conclusion
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Motivation
How do we determine if a given stock or
the overall market is currently
undervalued, overvalued or fairly valued?
 Popular measures of valuation:

◦ Dividend-to-Price ratio (D/P), Earnings-to-Price ratio
(E/P), Book-to-Market ratio (B/M), EBITDA-toEnterprise value ratio (EBITDA/EV).
◦ High values indicate undervaluation.

Earnings, Dividends, Book, etc. are proxies
for intrinsic/fundamental value (V).
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What is intrinsic value?

The intrinsic value is the present value of expected
future free cash flows discounted at a risk-adjusted cost
of capital:

In efficient markets, Price (P) = Intrinsic Value (V). If
markets are not efficient, then Price doesn’t have to
equal Intrinsic Value.
If (V > P), the security is undervalued; if (V < P), the
security is overvalued, Graham and Dodd (1934).
In practice, we use accounting variables such as earnings,
operating income, book, etc. as proxies of (V).
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Dividend-to-Price (D/P) Ratio
Aggregate dividends divided by aggregate
market capitalization (also referred to as
dividend yield).
 Widely used to predict market returns in
academic studies:

◦ Fama and French (1988)
Since the 1980s, firms have substituted
stock repurchases for dividends.
 Perhaps misleading to compare current
D/P to historical D/P.
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Forward Earnings-to-Price (FY1/P)
One-year ahead analyst earnings forecasts
divided by aggregate market capitalization.
 It incorporates expected future earnings
growth rates and, therefore, reflects
current economic expectations.
 On the other hand, it is still an annual
measure which can be cyclical and noisy.
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Shiller’s 10-year Average Earningsto-Price Ratio (E10/P)
Since annual earnings are cyclical and noisy,
Campbell and Shiller (1988) propose a trailing
10-year average earnings-to-price ratio, E10/P.
 It is just the inverse of Shiller’s cyclically
adjusted P/E (CAPE) measure.
 10-year average earnings is likely to be more
smooth and arguably a better measure of
fundamental value than 1-year earnings.
 On the other hand, it is backward looking and
can be heavily influenced by one negative event.
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EBITDA-to-Enterprise Value
Aggregate EBITDA divided by Enterprise Value.
 EBITDA = Earnings Before Interest and Taxes
(EBIT) + Depreciation & Amortization (DA).
EBIT+DA=EBITDA.
 EBITDA represents the operating cash flows of a
company and is less noisy than Earnings
although it is also a one-period measure.
 Enterprise value is the sum of market value of
equity, debt, and preferred stock less excess
cash.
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Book-to-Market (B/M) Ratio
Aggregate book value of equity divided by the
market value of equity.
 The book value of equity is another measure of
fundamental value.
 Unlike annual earnings, book is the sum of all
past retained earnings and hence is a smoother
measure than earnings.
 Book value, however, excludes the value of
intangible assets and could underestimate the
fundamental value of growth companies.
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Is there a better way?
All these measures use very noisy proxies
of intrinsic value.
 And, each measure has its own problems.
 And, they do a poor job of predicting
future returns
 Can we do better? Can we use intrinsic
value models?
 How would intrinsic value models fare in
comparison to these valuation ratios?
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Intrinsic Value Approach

The discounted cash flow model can be used to
directly estimate the intrinsic value of a stock:
Lee, Myers and Swaminathan (1999) estimate the
intrinsic value of the Dow 30 stocks using analyst
earnings forecasts and show that a Value-to-Price
(V/P) ratio predicts future market returns better.
 The difficulty is in estimating the cost of equity re.
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Implied cost of capital (ICC)

Instead, estimate the cost of equity (re) from the intrinsic
value model by setting, Price = Value:
re is the internal rate of return (IRR) that equates the
present value of future cash flows to current stock price;.
 Like the yield to maturity (YTM) on a risk-free bond.
 In efficient markets, P = V, and re should represent the
rational expected return. If markets are not efficient, re
will be too high for undervalued stocks and too low for
overvalued stocks.
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Implied cost of capital

Academic papers using this approach:
◦ Average risk premium: Claus and Thomas (2001), Fama and French (2002);
◦ Cross-sectional asset pricing (betas and characteristics): Kaplan and
Ruback (1995), Botosan (1997), Gebhardt, Lee, and Swaminathan (2001),
Easton and Monahan (2005);
◦ International asset pricing: Lee, Ng and Swaminathan (2009);
◦ Default risk and expected stock returns: Chava and Purnanandam (2010);
◦ Time-series: Pastor, Sinha, and Swaminathan (2008) on inter-temporal riskreturn trade-off.

Li, Ng and Swaminathan (2013, forthcoming, Journal of
Financial Economics) use this approach to compute a
forward looking risk premium measure for the S&P 500.
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Two reasonable economic assumptions

A firm cannot grow faster than the
economy forever:
◦ Earnings growth rates should converge to the
nominal GDP growth rates in the long run.

Competition drives economic profits to
zero:
◦ The return on new investments (ROI) should
converge to the cost of capital in the long
run.
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How do we compute the ICC?

Divide the infinite horizon model into 2 parts:
T=15, ‘FE’ is the forecasted earnings and ‘b’ is the
plowback rate. ICC is based on forward-looking
smoothed cash flows.
FEt k  FEt k 1  1  gt k 
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How do we compute the ICC?
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Use analyst forecasts of earnings FY1 and FY2.
Assume the growth rate implicit in the two forecasts,
g2=FY2/FY1-1, mean-reverts to the nominal GDP growth
rate by Year 15. Use these growth rates to project future
earnings.
Plow back rate = 1 – Payout Ratio. Set plowback rate for
Year 1 equal to last year’s plowback rate. Mean-revert the
plowback rate to a long-term value by Year 15.
Estimate future cash flows and compute the ICC for every
firm in the S&P 500 from January 1977 to September 2013.
Value-weight individual ICCs to obtain the ICC of S&P 500.
Subtract the yield on the 1-month Treasury Bill or the 30year Treasury Bond to compute the implied risk premium.
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How do these measures predict
future market returns?
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In the paper, we examine how these various
measures have performed in predicting market
returns over the next 4 years.
I will present the results for predicting the next
3-year returns.
Regression: R3YR = a + b*X
‘R3YR’ is the dependent variable and ‘X’ is the
independent variable.
‘a’ is the intercept, ‘b’ is the slope coefficient.
X = D/P, E/P, B/M, E10/P or ICC.
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Predictability Findings
Predicting next 3-year U.S. Market Returns
1977-2012
Variable X
D/P
E/P
B/M
E10/P
ICC
Slope (b)
2.25
0.71
0.11
0.62
1.77
T-statistic
1.42
1.05
1.18
1.21
3.18
R-Square
8.0%
5.0%
6.0%
6.0%
27.0%
T-statistic measures statistical reliability. T-statistic > 2 indicates there
is 95% confidence in the results.
R-Square measures how much of the variation in next 3 year returns is explained
by the independent variable X.
ICC is the risk premium with respect to 1-month T-bill. Only ICC
predicts future returns in a statistically significant manner.
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Conclusions
Popular measures of market valuation all suffer
from various conceptual problems.
 ICC is a theoretically superior approach that
relies on discounted cash flow models and is
based on smoothed forward-looking cash flows.
 It is also an empirically superior measure that
has the best predictive power for market
returns over the next three years.
 The methodology can also be used to estimate
style premium between Value and Growth, Low
Volatility and High Volatility etc.
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