Chapter 4

Multivariable and Factor

Valuation

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 Extended CAPM
• Allowance for a tax effect

• The presence of inflation

• Market capitalization

• P/E and M/B value effects

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 Allowance for the Tax Effect
• Dividends
– Tax wedge
• Capital gain or loss
– PV advantage
• Systematic bias effect
• Three-dimensional relationship


R j tiltR f  b j  t d j  R f
• Yield 
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Three-Dimensional Security Market
Surface Illustrating a Tax Effect
Figure 4-1

Security Market Surface

Expected return

)
eta
(b
i sk
Div r
iden t ic
d a
yiel te m
d s
Sy
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 The Presence of Inflation
• Add an inflation premium
• Unanticipated changes
– Covariance of uncertainty with the stock is
desirable
• Adding an inflation variable
– Covariance with inflation
• Desirable
• Undesirable

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 Market Capitalization Size
• Number of shares outstanding x share price

• Small stock effect

– Provides less utility
– Requires a higher return

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 P/E and M/B Value Effects
• P/E ratio
– Observed returns
• Higher for low P/E ratio stocks
• Lower for high P/E ratio stocks
– Form of mean reversion
– Important in tempering return estimates
• M/B ratio
– Observed returns
• Higher for low M/B ratio stocks
• Lower for high M/B ratio stocks
• Fama and French

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 Final Observations
Size
Consistent & Significance P/E
M/B
Dividend-Yield Effect Most Controversial
Precise Measurements
Extensions
Market Equilibrium
Beta Dominant

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 Factor Models in General
• Two-factor model
– Only the factor risks are important
– Unanticipated changes matter
• Equilibrium conditions to be upset
• Security prices to change
• More than two factors
– Economic variables
– Behavioral variables

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 Arbitrage Pricing Theory
• The arbitrage process

• Roll-Ross and their five factors

• Other empirical testing

• Implications of the APT for this book

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 APT
• An equilibrium model
• Developed by Ross
• Arbitrage eliminates itself
– Profit opportunities become exhausted
Security Returns
• Relationship
Limited Number of Factors
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 The Arbitrage Process
• Buy the security with the higher expected
return
• Sell short the security with the lower
expected return
• Price adjustment will occur
• Foundation for equilibrium pricing is
arbitrage

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 Roll-Ross and Their Five Factors
• Change in expected inflation
• Unanticipated changes Affect
– In inflation primarily
– In industrial production cash
– In the yield differential flows
• Between low- and high-grade bonds
Affect • The default-risk premium
market – In the yield differential
capital- • Between long-term and short-term bonds
ization • The term structure of interest rates

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 Other Empirical Testing
• No agreement on important risk factors
• No agreement on the number of factors
• Inconclusive testing
• No superior models
• Estimates are subject to wide error

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 Implications of the APT for
This Book
• Intuitively appealing
– Relating security returns to underlying
risk factors
– Provide better understanding of the
economic forces that affect share price
• APT has not displaced the CAPM

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