investing with a stock valuation model - yale university.pptVIP

Investing with a Stock Valuation Model Zhiwu Chen, Yale University Ming Dong, Ph.D. candidate, OSU Purpose Models: The stock valuation model developed by Bakshi Chen (1998) and extended by Dong (1998) The residual-income model implemented in Lee-Myers-Swaminathan (1997) To compare their performance to traditional stock-selection measures: book/market, P/E, momentum, size, and so on Motivation: why not expected-return models? The CAPM, APT and other multi-factor models all focus on EXPECTED FUTURE RETURNs Stock-Selection Idea: if the actual expected return on IBM is higher than its deserved expected return, then IBM is a buy (hence, Jensen’s Aplha) But, what is IBM’s actual expected 1-yr-forward return today? ----- You cannot observe it! Conclusion: you cannot really apply such expected-return models. Motivation: why stock-valuation models? There is always a market price for each stock ! Stock-Selection Idea: if IBM’s market price is lower than its model price (fair value), then IBM is a buy (hence, undervalued stocks) Conclusion: stock valuation modeling is the way to go. But, is there a “good” equity-valuation model? Motivation: existing stock valuation models Variants of the Gordon model: too many unrealistic assumptions (e.g., a constant and flat term structure, constant dividend growth forever) Multi-stage dividend/earnings/cashflow discount models: No structural parameterization of the firm’s business No attention paid to how the stock has historically been valued by market Fair values determined by these models are too often below market price. The Bakshi-Chen-Dong (BCD) Model Fundamental Variables: current EPS, expected future EPS, and 30-yr bond yield Firm-specific parameters: EPS growth volatility Long-run EPS growth rate Duration of business-growth cycle Systematic or beta risk of the firm Correlation between the firms EPS and the interest-rate environment 30-yr Treasury yield’s parameters: Its lon