LOS d: Demonstrate the use of the capital asset pricing model (CAPM), Fama–French model (FFM), the Pastor–Stambaugh model (PSM), macroeconomic multifactor models, and the build-up method (including bond yield plus risk premium method) for estimating the required return on an equity investment.

Statement 1 is not good advice because in some cases market inefficiencies will prevent the price from converging with intrinsic value. As such, Matin’s advice is not sound. Statement 2 is good advice, as the Pastor-Stambaugh model adds a liquidity factor to the traditional Fama-French model. Such a liquidity factor would be useful in the analysis of a thinly traded stock.

Supply-side models work best in developed countries, where public equities represent a significant share of the economy, suggesting that there is a relationship between macroeconomic variables and asset prices. The use of a supply-side model suggests Smith Sprockets is in a developed market. Build-up models are generally used for closely held companies for which betas are not easy to obtain. Bondillo’s use of a build-up model suggests Smith Sprockets is probably closely held. Betas of public companies must be adjusted for drift. However, since the use of the build-up method suggests the company is closely held and has no beta available, beta drift is probably not relevant for Smith Sprockets.

The build-up method takes into account a company’s size and is usually applied to closely held companies for which beta is not available. The Pastor-Stambaugh method is a modified version of the Fama-French factor model that considers liquidity.

The build-up method assigns premiums based on company size and other company-specific factors. It is designed for use on closely held companies and does not take inflation changes into account. The bond-yield method adds a risk premium to the yield on the company’s publicly traded debt. The bond yields will reflect inflation indirectly, but the model does not easily adjust for inflation changes. For taking rapid inflation changes into account, a multifactor model works the best.

Action A is a useful method for calculating beta for private or thinly traded companies. With that estimated beta, Hoyle has all the pieces needed to calculate required return using the capital asset pricing model. Action B reflects the bond-yield plus risk premium method for calculating required return on equity for companies with publicly traded debt. This strategy would provide Hoyle with a target return. The model created in Action C is useful for estimating an equity risk premium. But Hoyle already has an equity risk premium. (Study Session 10, LOS 36.b)

Strinson is not publicly held, and its shares have little liquidity. The Fama-French model is useful for estimating returns, but the Pastor-Stambaugh model adds a liquidity factor to the Fama-French model. As such, the Pastor-Stambaugh model is probably better for a company like Stinson because it takes liquidity into account. The CAPM requires the estimation of beta and is likely to be less accurate than the other models. (Study Session 10, LOS 36.d)

Both the build-up method and the bond-yield plus risk premium method work for thinly traded companies. But the build-up method relies on historical estimates, so it wouldn’t work well for Halberd, which has minimal historical data. Thus, the bond-yield plus risk premium method is the best option. The country spread model is not designed to calculate an expected return, but instead to adjust data from emerging markets for comparison with data from developed markets. The question only provides two options, and the CAPM is the only model that would actually do the required job for Jones. (Study Session 10, LOS 36.d)

Macroeconomic models work for any market in which public equities represent a large enough share of the economy that analysts can reasonably infer a relationship between economic factors and asset prices. Since South Pittson Island is known as a tax haven, it is likely that many other companies are domiciled there for the same reason Jones Group is, and the financial industry is a large part of the economy. However, even if we don’t want to assume that South Pittson Island’s economy is suitable for such models, we have another argument. Jones Group is one of the world’s largest consulting companies. Therefore, it is highly likely that it has significant operations in large, developed markets. Macroeconomic models can be constructed to reflect data from those markets – and in fact, any such model should reflect that data.

While Halberd is closely held, that status should not affect a macroeconomic model, which looks at broad factors that affect both public and private companies. We need not have a beta or historical trading data to use such a model. (Study Session 10, LOS 36.d)

Currency-translation issues are a concern for any company with operations in foreign countries. But the country spread model is designed to adjust results from emerging markets using data from developed markets, assigning the proper amount of extra risk for the emerging market. Most tax havens would not need to be treated as emerging markets. In addition, as one of the world’s largest consultancies, Jones Group must do a lot of business in the U.S. and other developed markets. It is unlikely that results from a company like Jones Group would require the adjustments from the country spread model. Regarding beta: Since Jones is publicly traded, there is no need to extrapolate a beta using data from another company. Thus, there is no reason to unlever beta from a benchmark company, then relever it to reflect Jones’ financial condition. The biggest concern is the overall effectiveness of the CAPM. The model should work for Jones Group, but it has weaknesses, most importantly its dependence on just one factor. Jones trades on at least two exchanges, and any model depending on just one market index is not going to reflect the whole picture. (Study Session 10, LOS 36.g)