Investments: Principles of Portfolio and Equity Analysis, coedited by Michael G. McMillan, Jerald E. Pinto, Wendy L. Pirie, and Gerhard Van de Venter (Wiley, 2011), was written for financial analysts as well as aspiring financial analysts. Part of the CFA Institute’s book series, it is a weighty tome of more than 600 pages. In twelve chapters it covers such topics as market organization and structure, security market indices, market efficiency, portfolio management, portfolio risk and return, portfolio planning and construction, equity securities, industry and company analysis, equity valuation, equity market valuation, and technical analysis. There is also a separate paperback workbook with problems and solutions.

I debated what to focus on in this post and finally decided to look at two methods for valuing equity markets. The assumption is that, whatever the short-term effects of momentum, “economic fundamentals will ultimately dictate secular equity market price trends.” (p. 470) (For those who read yesterday’s post, this assumption is in sync with the theory of Frydman and Goldberg.)

First is the neoclassical approach to growth accounting, which uses the Cobb-Douglas production function to “measure the contribution of different factors—usually broadly defined as capital and labor—to economic growth and, indirectly, to compute the rate of an economy’s technological progress.” In imprecise and non-mathematical terms, the percentage growth in real output (or GDP) can be decomposed into its components: growth in total factor productivity (a measure of the level of technology), growth in the capital stock, and growth in the labor output. Applying this model to the Chinese economy, the authors of the chapter suggest that Chinese economic growth will eventually moderate; nonetheless, they project a near-term growth rate of 9.25%. They arrive at this by adding total factor productivity of 2.5%, a growth in capital stock of 12% times a value of 0.5 for the output elasticity of capital—that is, 6%, and a labor force growth of 1.5% times a value of 0.5 for the output elasticity of labor—or 0.75%. An ultimately sustainable growth rate might be 4.25% [1.25% + (0.5 x 6%) + (0.5 X 0%)]. (more…)