Grinold-Kroner

CFA Level III Economics
#1

Hi all. I really hope someone can help.

This question relates to Grinold-Kroner.

I have the following to solve and I am failing to see how but the lecturers tell me all the info required to solve it is provided… So clearly I am missing something. If anyone here could please suggest what I’m not seeing I would be grateful! The question is: CG is a market forecaster with IIM. CG is asked to review the current economic conditions and market outlook for country X and to set long- term market return expectations for domestic equities. These expectations will form the basis of IIM’s future client asset allocations. CG gathers Country X capital market data displayed below. Equity compounded annual growth rate: 9.0% Equity risk premium: 4.3% Dividend yield: 6.0% Equity repurchase yield -0.5% Real earnings growth return: 2.6%

Current and Forward Looking Data Current equity price-to-earnings ratio 12.2 Expected equities real earnings growth rate: 3.5% Expected long-term inflation rate: 3.1% Using Grinold-Kroner model determine the component sources of the historical nominal return for Country X equities: (i) Income return (ii) Earnings growth (iii) Repricing return My problem is with (ii) and (iii) because for (ii) (as far as I’m concerned) we need historical inflation; for (iii) we need more than one PE in order to work out the repricing difference (or we could work backward from the CAGR IF we had the components for (ii)… As mentioned, the people who set the question are adamant it is solveable. PLEASE someoen tell me what I am missing. I will have little to no internet over the next few days/ weeks so I may not respond to follow-up questions but I will definitely TRY to log in. Thanks!!

#2

I) Income Return

d/p + change in share repurchases = 6% - 0.5% = 5.5%

II) Earnings Growth

i = expected inflation rate not historical

i + g = 3.1% + 2.6% = 5.7%

III) Repricing Return

We need to fin expected P/E meaning P/ E1

so it is P/[E X(1+g)] = 12.2 / (1+ (3.5% + 3.1%) = 11.44

so change in P/E = 11.44/12.2-1 = -6.23%

Pl. improve upon this, i may be wrong

#3

I’d take Expected equities real earnings growth rate: 3.5% instead of Real earnings growth return: 2.6% for earnings growth

#4

You’re probably wrong. The whole problem here is finding historical inflation.

We want the breakdown of the historical return, not of expected ones.

#5

yep, my bad. Sorry.

#6

i always thought its about expected inflation, can you pl. google?

#7

You have to derive P/E change from the Equity compounded annual growth rate

what they call “Equity compounded annual growth rate” is the result of the model.

Hence, Equity compounded annual growth rate= d/p + change in share repurchases +i +g +DeltaP/E

vgmalu already solved , d/p + change in share repurchases +i +g

This question was raised in the same wording in 2008 or 2009 AM (i will check at home)

#8

I got this on wiki

Expected Returns= Div1 /P0 + i + g - ΔS + Δ (P/E)[1]

Div1 = dividend in next period (period 1 assuming current t=0) P0 = current price (price at time 0) i= expected inflation rate g= real growth rate in earnings (note that by adding real growth and inflation, this is basically identical to just adding nominal growth) ΔS= changes in shares outstanding (i.e. increases in shares outstanding decrease expected returns) Δ(P/E)= changes in P/E ratio (positive relationship between changes in P/e and expected returns).

#9

We don’t have neither i nor delta P/E

We only have the historical cost of equity, which we should somehow use to derive the real rate (or inflation) from the remaining inputs.

#10

oh…so it is reverse engineering,(fit the model)

maybe u r right, i hope mr. smart comes up with the right answer to help this guy

#11

One method:

Derive the payout ratio from the current P/E, assuming the Div yield hasn’t changed

DPR = 71%

If that hasn’t changed historically, then:

Old PE = 71%/6% = 11.83

Repricing return is 3.12%

Earnings growth is 9+0.5-6-3.12 = 0.38%

Too many assumptions, the thing is, I could come up with several other methods, all with different answers.

I don’t think there is a way around it, you have to make an assumption at some point. Here, I did with D/P remaining constant.

#12

@vgmalu - the Managing INvestment Portfolios textbook asys it can be used to derive the composition of returns for historical returns, and this question definitely wants historical not expected so I’ve used historical wherever given…

@ MrSmart, you might be right on the deriving PE from divyield (its not covered at all in the module info so its a real curveball if that IS what is required).

I took expected inflation and wrote that I assumed historical was the same…

Then used the CAGR - income return - earnigns growth to give me repricing…?

#13

Are you sure its Real earnings growth return: 2.6% and not Nominal earnings growth return (%)?

AM 2009 Q5 A is the same exercice but with Nominal earnings growth return.

#14

I copied and pasted directly from my assignment. But funny that there’s this discrepancy… It wouldn’t surprise me if the lecturers changed something but maybe they miscalculated. Still, they INSIST the question is solvable…

#15

Q5 2009 AM states:

Robert Spencer is a market forecaster with Windsor Investment Management, a U.K.-based wealth management firm. Spencer is asked to review the current economic conditions and market outlook for the U.K. and to set long-term market return expectations for domestic equities. These expectations will form the basis of Windsor’s future client asset allocations. Spencer gathers the U.K. capital market data displayed in Exhibit 1.

Exhibit 1 U.K. Capital Market Data Historical Data (past 100 years)

Equity compounded annual growth rate (%) 11.2

Equity risk premium (%) 5.3

Dividend yield (%) 4.0

Equity repurchase yield (%) –0.5

Nominal earnings growth return (%) 4.6

Current and Forward Looking Data:

Current equity price-to-earnings ratio 14.6 %

Expected equities real earnings growth rate 2.7 %

Expected long-term inflation rate 2.5 %

A. Determine, using the information in Exhibit 1 and the Grinold-Kroner model, the component sources of the historical nominal return for U.K. equities: i. income return ii. earnings growth iii. repricing return

Answer:

i)Income return is the sum of the dividend yield (i.e., D/P, which is 4.0%) and the equity repurchase yield (i.e., the negative of the expected change in shares outstanding, - ∆S) which is -0.5%. Therefore: Income return = D/P - ∆S = 4.0 - 0.5 = 3.5%

ii. Earnings growth is the sum of real growth in earnings and the inflation rate. This sum is shown in Exhibit 1: Earnings growth = 4.6% (given in Exhibit 1)

iii. Repricing return: Since the equity compounded annual growth rate is given in Exhibit to be E(Re) = 11.2%, the Grinold-Kroner model can be rearranged to solve for repricing return: 11.2% = 3.5% + 4.6% + Repricing return . Rearranging the terms: Repricing return = 11.2% – 3.5% – 4.6% = 3.1%

#16

Thanks Blackou… I guess I will have to wait and see how the lecturers resolve the “twist” they introduced…

#17

Who cares? The exam is over…and if you studying for next year you’re starting too early so…who cares?

#18

University assignment

#19

That makes sense.