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Study Session 9: Equity Valuation: Valuation Concepts

CFA Curriculum Reading 28 Return Concepts Q.9


please explain this question. 

Q. In the current interest rate environment, using a required return estimate based on the short-term government bond rate and a historical equity risk premium defined in terms of a short-term govt. bond rate would be expected to :

  • bias long-term required return on equity estimates upwards.
  • bias long-term required return on equity estimates downwards.
  • have no effect on long-term required return on equity estimates

What does all of this mean? Its so confusing.

    Realized Alpha


    So isn’t the formula for realized alpha = actual holding period return - Contemporaneous required return?

    Because in a question its solved like this:  actual holding period return - required return of the same stock on a weekly basis.

    Required rate of return


    So when calculating required rates of return with average systematic risk (i.e. beta) are we supposed to use the geometric mean return relative to 10-year govt. bond returns over 10 years or yields of 10-year govt. bonds. Why do we use it (whichever it is)? 

    Also does average systematic risk means a beta of 1? and why?


    P/E vs Earnings Yield (E/P)

    This phase is from Schewser: “Negative earnings render P/E ratios meaningless. In such cases, it is common to use normalized EPS and/or restate the ratio as the earnings yield (E/P) because price is never negative. A high E/P suggests a cheap security, and a low E/P suggests an expensive security, so securities can be ranked from cheap to expensive based on E/P ratios.”

    Not quite sure I follow this.

    If earnings is negative, using PE ratio is meaningless because it makes PE negative (okay get this part)…

    Justified leading vs trailing PE and undervalued vs overvalued

    If the industry has a justified leading PE of10 and while the stock has a justified leading PE of 12, then obviously the stock is overvalued (expensive).

    However, I just ran into a question where the justified trailing PE for the industry is 10, while the stock’s justified trailing PE is 12 – answer explained that the stock was undervalued but it didnt give further explaination.

    Is this because trailing PE already occurred so the comparison is the opposite of justified leading PE?

    historical equity risk premium

    Hi, just need some help understanding the rationale behind CFAI reading 28 “Return Concepts” EOC questions #8-9 regarding bias of equity risk premium and return on equity estimates.

    I don’t know if I’m allowed to copy/paste straight from CFAI text..


    CFA Curriculum; Vol 5; page 96; Exhibit 24. Can anyone please explain how those present values were calculated or which values were discounted to arrive at, for example, the PV of 95.72908 for Path 1? Thanks.

    FCFE question on depreciation / NCC

    So FCFE = NI + NCC -FCInv -WCinv + net borrowing.

    So if you have NI of 5, depreciation of 2, FCInv of 1, WCinv of 1 and 0 net borrowing, its pretty simple: 5+2-1-1+0 =5

    However, some of the questions have a debt ratio and then the equation gets rewritten like this:

    FCFE = NI -  (FCInv - depreciation)*(1-d/r) - (WCInv * (1-dr)) + net borrowing

    Swap rate vs Z spread

    As per my understanding, both help measure the credit and liquidity risk in a swap transaction over a T-bill. While swap rate is calculated using the YTM, the Z spread is calculated using spot rates. I am trying to understand why we need them both if both help quantify the same thing? Also, spot rates can be derived from YTM (and vice versa..), how do we end up with different values of Z spread and swap rate? Shouldn’t they be the same?

    Economic value - book or market value?

    To calculate economic profit, we deduct a capital cost from operating profit. Why do we use market value of debt and equity to calculate WACC, but then use the book value to calculate $WACC. This seems inconsistent.

    I don’t understand why book value is used at all. The $WACC is an opportunity cost and book value is somewhat arbitrary. If the company has gone through M&A the book value will be higher compared to organic growth.

    What is not arbitrary is market value, so why not use it?