{"id":39542,"date":"2024-07-31T07:01:19","date_gmt":"2024-07-31T07:01:19","guid":{"rendered":"https:\/\/analystprep.com\/study-notes\/?p=39542"},"modified":"2025-12-19T16:55:55","modified_gmt":"2025-12-19T16:55:55","slug":"equity-forecasting-2","status":"publish","type":"post","link":"https:\/\/analystprep.com\/study-notes\/cfa-level-iii\/equity-forecasting-2\/","title":{"rendered":"Equity Forecasting"},"content":{"rendered":"<p><iframe loading=\"lazy\" src=\"\/\/www.youtube.com\/embed\/h2N19J-ZqEg\" width=\"611\" height=\"343\" allowfullscreen=\"allowfullscreen\"><\/iframe><\/p>\n<h2>Historical Statistical Approaches<\/h2>\n<p><script type=\"application\/ld+json\">\n{\n  \"@context\": \"https:\/\/schema.org\",\n  \"@type\": \"QAPage\",\n  \"mainEntity\": {\n    \"@type\": \"Question\",\n    \"name\": \"Which of the following inputs to the Grinold-Kroner Model will most likely reduce the expectations for an equity market premium?\",\n    \"text\": \"Which of the following inputs to the Grinold-Kroner Model will most likely reduce the expectations for an equity market premium?\",\n    \"answerCount\": 3,\n    \"acceptedAnswer\": {\n      \"@type\": \"Answer\",\n      \"text\": \"An increase in share repurchases.\"\n    },\n    \"suggestedAnswer\": [\n      {\n        \"@type\": \"Answer\",\n        \"text\": \"An increase in growth.\"\n      },\n      {\n        \"@type\": \"Answer\",\n        \"text\": \"An increase in the payout ratio.\"\n      }\n    ]\n  }\n}\n<\/script><\/p>\n<p>Historical statistical approaches involve the collection of data from past returns and using them to extrapolate future performance. Using a pure-historical returns approach to forecast equity market returns is complicated because equities have a high standard deviation relative to their mean returns. This means data can often be misleading.<\/p>\n<p>Generally, developed economies\u2019 equity returns tend to range from 4.5% to 9.5%.<\/p>\n<h2>Discounted Cash Flows Approach<\/h2>\n<p>Building on the constant growth, or Gordon Growth Model, is the Grinold-Kroner Model. While simplistic, the constant growth model provides a distinct advantage over historical estimates. It attempts to look toward the future to project development and growth rather than simply capturing what the past has delivered. The Grinold-Kroner Model expands on the constant growth model by allowing for adjustments from share repurchases and overall market valuations.<\/p>\n<h3>Grinold-Kroner Model<\/h3>\n<p>$$ E(R_i) \\approx \\frac {D}{P} + (\\% \\Delta E &#8211; \\% \\Delta S) + \\% \\frac {\\Delta P}{E} $$<\/p>\n<p>Where:<\/p>\n<p>\\(E(R_i)\\) = Expected equity return.<\/p>\n<p>\\(\\frac {D}{P}\\) = Dividend yield.<\/p>\n<p>\\(\\% \\Delta E\\) = Expected percentage change in total earnings.<\/p>\n<p>\\(\\% \\Delta S\\) = Expected percentage change in shares outstanding.<\/p>\n<p>\\(\\% \\frac {\\Delta P}{E}\\) = Expected percentage change in the P\/E ratio.<\/p>\n<p>It is important to note that the equation contains a negative relationship with share repurchases. A rise in share repurchases will decrease the expected equity market premium. All other components of the Gordon Growth Model are present, including a breakout for inflationary expectations and a change in the price-to-earnings ratio.<\/p>\n<h3>Singer-Terhaar Model<\/h3>\n<p>The Singer-Terhaar Model builds on the international CAPM approach by assuming a wholly segmented market, then a completely integrated market, and then adding an adjustment for the degree of integration.<\/p>\n<p>International CAPM<\/p>\n<p>$$ R_i = R_f + \\beta(R_m \u2013 R_f) $$<\/p>\n<p>Where:<\/p>\n<p>\\(R_i\\) = Expected return.<\/p>\n<p>\\(R_f\\) = Risk-free rate.<\/p>\n<p>\\(\\beta\\) = Beta.<\/p>\n<p>\\(R_m\\) = Expected equity market return.<\/p>\n<h3>Singer and Terhaar Analysis<\/h3>\n<p>$$ \\begin{align*} ERP_i &amp; = \\left[ \\left(\\text{Degree of integration} \\right) \\times \\sigma_i \\times \\rho_{(i,m)} \\times \\frac {(ERP_m)}{\\sigma_m} \\right] \\\\ &amp; + \\left[ \\left(\\text{Degree of segmentation}) \\times \\sigma_i \\times \\frac {((ERP_m)}{\\sigma_m} \\right) \\right] \\end{align*} $$<\/p>\n<p>Where:<\/p>\n<ul>\n<li>\\(ERP_i\\)=Equity risk premium of a partially integrated market.<\/li>\n<li>\\(\\rho_{(i,m)}\\)=Correlation of market with global portfolio.<\/li>\n<\/ul>\n<h4>Explanation<\/h4>\n<p>The equity risk premium is the return over and above the risk-free rate. It is hard to forecast the equity premium, and analysts have to decide on the degree of integration\/segmentation. It is noteworthy that equity and bond markets of developed countries are highly integrated; hence, a range of 0.75\u20130.90 is suitable. On the other hand, equity and bond markets of emerging markets are less integrated, so a range of 0.50\u20130.75 is more appropriate. Analysts are advised to couple forecasts with other methods of analysis.<\/p>\n<blockquote>\n<h2>Question<\/h2>\n<p>Which of the following inputs to the Grinold-Kroner Model <em>will most likely<\/em> reduce the expectations for an equity market premium?<\/p>\n<ol type=\"A\">\n<li>An increase in growth.<\/li>\n<li>An increase in the payout ration.<\/li>\n<li>An increase in share repurchases.<\/li>\n<\/ol>\n<h4>Solution<\/h4>\n<p><strong>The correct answer is C<\/strong>.<\/p>\n<p>An increase in outstanding shares would decrease the expected return. Note that share repurchases are a way of returning cash to investors. Shares outstanding are the denominator in the price per share formula, while total equity is the numerator. Therefore, all things equal, a larger denominator will reduce the quotient, which is the price per share. This is synonymous with capital depreciation or reducing return.<\/p>\n<p><strong>A is incorrect<\/strong>. An increase in growth would increase the expectations for an equity market premium. The Grinold-Kroner Model includes the real growth rate in earnings as one of its inputs. An increase in the real growth rate in earnings would increase the expected return on a stock or stock market index.<\/p>\n<p><strong>B is incorrect<\/strong>. An increase in the payout ratio would also increase the expectations for an equity market premium. The Grinold-Kroner Model includes dividend yield as one of its inputs. An increase in the payout ratio would increase the dividend yield, increasing the expected return on a stock or stock market index.<\/p>\n<\/blockquote>\n<p><strong>Asset Allocation: Learning Module 2: Capital Market Expectations &#8211; Part 2 Forecasting Asset Class Returns;<\/strong> Los 2(c) Discuss approaches to setting expectations for equity investment market returns<\/p>\n","protected":false},"excerpt":{"rendered":"<p>Historical Statistical Approaches Historical statistical approaches involve the collection of data from past returns and using them to extrapolate future performance. Using a pure-historical returns approach to forecast equity market returns is complicated because equities have a high standard deviation&#8230;<\/p>\n","protected":false},"author":3,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[571],"tags":[],"class_list":["post-39542","post","type-post","status-publish","format-standard","hentry","category-cfa-level-iii","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v26.9 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Equity Forecasting - CFA, FRM, and Actuarial Exams Study Notes<\/title>\n<meta name=\"description\" content=\"Historical statistical approaches involve gathering data on past returns and using the data to project future performance.\" \/>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/analystprep.com\/study-notes\/cfa-level-iii\/equity-forecasting-2\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Equity Forecasting - 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