Grinold and Kroner Model for valuation

Fundamental analysis is based on the notion that every security has an intrinsic value and if the security is trading above its intrinsic value its overvalued and must be sold and if it is trading less than its intrinsic value than it must be bought because it is undervalued. There are many models through which we can ascertain the intrinsic value of a security or through which we can find out what is the expected return from the security like dividend discount model, discounted cash flow models etc. Applied to equity markets, the most common application of discounted cash flow models is the Gordon growth model. It is most commonly used to back out the expected return on equity, resulting in the following
Expected Returns= Div1 /P0 + g

Where Div1 = dividend in next period (period 1 assuming current t=0) P0 = current price g = real growth rate in earnings In this case the growth rate is proxied by the nominal growth in GDP, which is the sum of real growth in GDP plus the inflation rate. The growth rate can be adjusted for any differences between the economy growth rate and that of the equity index. Grinold and Kroner took this model one step further by including a variable that adjusts for stock repurchases and changes in market valuations as represented by the price to earnings (P/E) ratio. The model states that the expected return on a stock is its dividend yield plus the inflation rate plus the real earnings growth rate minus the change in stock outstanding plus the changes in the P/E ratio: The model states that :

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) ?S = changes in shares outstanding (i.e. increases in shares outstanding decrease expected returns) ? (P/E) = changes in P/E ratio (positive relationship between changes in P/E and expected returns)

Example Suppose the analyst estimates a 2.1% dividend yield, long term inflation of 3.1%, earnings growth rate of 4%, a repurchase yield of -0.5% and P/E re pricing of 0.3%. The expected return on the stock is 2.1% + 3.1% + 4% - 0.5% + 0.3% = 9% Advantages of the model : Easy to calculate. Based on Gordon growth model. Incorporates market valuation factor by including Price to earnings ratio. Incorporate the effect of number of shares in the market. Provides the expected return on stock which can be compared with past return to analyze its worth. Can be applied to companies whose dividend is related to earnings. Disadvantages of the model : Difficult to estimate economic variables like growth rate and inflation. Dividend payout fluctuates with time. Growth rate is not constant. Difficult to apply in companies with inconsistent dividend policies. There are various advantages and disadvantages of using any equity valuation model so it should be noted that all these models should be back tested taking into account prior years data to ascertain the accuracy of the model used. References : Wikipedia - http://en.wikipedia.org/wiki/Grinold_and_Kroner_Model Richard Grinold and Kenneth Kroners white paper "The Equity Risk Premium," in Investment Insights published by Barclays Global Investors, July 2002. Author Box Kotak Securities is one of Indias largest share broking firm offering demat account, online trading, mutual fund and IPO investing services along with a research division specializing in Sectoral Research and Company Specific Equity Research. Express your views on their Facebook Page and Twitter Handle (@KotakSecurities) or you can also visit http://www.kotaksecurities.com for more information.