Chapter 11 Study Notes on Investment — Stock Market Valuation

Economic booms or recessions affect stock prices by influencing the risk-free rate, risk premium, and corporate earnings. It is widely accepted that stock prices are negatively correlated with both the risk-free rate and the risk premium, and positively correlated with earnings growth. In this section, we convert macroeconomic forecasts into corporate cash flow forecasts, then integrate these corporate forecasts with an appropriate discounted cash flow (DCF) model to estimate the intrinsic value of the overall stock market—specifically from the perspective of the theoretical price-to-earnings (P/E) ratio. 1. Stock Market Valuation Investors commonly use the market P/E ratio to assess the outlook for future stock returns. Fuller and Hsia developed a valuation model known as the H-model. In this model, the dividend growth rate over a finite trading horizon is assumed to decline linearly until it stabilizes at a constant, long-term rate—akin to an annuity or terminal-stage growth rate. The model incorporates three key parameters: the initial dividend growth rate in the final stage (gs), the number of years (N) over which the dividend growth rate declines linearly, and the long-term, stable dividend growth rate (gl) prevailing at the beginning of the annuity phase—or equivalently, at the end of year N. Assuming the initial annual dividend at time zero is D₀, the discount rate for the annuity is r, and the estimated intrinsic value at time zero is V₀, the H-model is expressed as follows. The H-model was originally designed as a convenient framework for modeling situations where a high initial dividend growth rate gradually transitions to a lower, sustainable long-term growth rate. However, when valuing mature, developed equity markets—where no supernormal growth exists—the Gordon Dividend Growth Model is more commonly used than the H-model. 2. Forecasting Methods for Stock Returns There are two primary approaches: top-down and bottom-up. In top-down forecasting, macroeconomic forecasts are used to predict returns for broad equity indices. These forecasts can then be refined down to specific market sectors and industry clusters within the index. Key steps include: • Market Analysis: Examine valuations across different equity markets to identify those offering expected excess returns. • Compare relative valuation metrics of individual equity markets against their historical averages to identify relatively cheap or expensive markets. • Analyze trends in relative valuation metrics across markets to gauge market momentum. • Compare the expected returns of equity markets anticipated to deliver excess returns against those of other asset classes (e.g., bonds, real estate, commodities). • Industry Analysis: Assess domestic and global business cycles to identify industries expected to outperform within the strongest-performing equity markets. • Compare relative growth rates and expected profit margins across industries. • Identify industries likely to benefit positively from expected trends in interest rates, exchange rates, and inflation. • Company Analysis: Within the best-performing industries of the strongest-performing equity markets, select the highest-potential individual stocks. Bottom-up forecasting begins with micro-level fundamental analysis of individual companies. Analysts use such information to forecast investment returns for each stock. Specific steps include: • Company Analysis: Identify the fundamental reasons why certain stocks may outperform the broader market—without reference to current macroeconomic conditions. • Determine why a company’s products, technology, or services are expected to succeed. • Evaluate the company’s management quality, track record, business model, and growth prospects. • Estimate expected returns for each stock using a discounted cash flow model. • Industry Analysis: Aggregate the expected returns of stocks within an industry to identify the strongest-performing sectors.

Plummeted 83%, Then Soared 8-Fold, Burned $2.3 Billion—All for a Piece of Paper No One Else Can Replicate

Why Utah? Because Utah is a regulatory haven for fintech in the U.S.—more than half of all Industrial Loan Companies (ILCs) in the country are chartered there. It offers tax-friendly policies, light-touch regulation—and most critically—parent companies holding an ILC can bypass Federal Reserve oversight as bank holding companies. A smart choice. Then, in September 2017, the plot took a sharp turn. Two former employees filed lawsuits alleging sexual harassment by CEO Anthony Cagney. Within a month, Cagney was forced to resign—and the ILC charter application was withdrawn. A former SEC Chair once said something I believe every fintech professional should engrave in their memory: “When U.S. regulators review applications for bank charters, they don’t just scrutinize your financial models—they scrutinize *you*. They ask: Are you trustworthy?” Cagney wasn’t. So everything reset to zero. A bank charter isn’t merely a commercial license—it’s a seal of trust. Is your company prepared to withstand that level of scrutiny? ────────── 2020: A New Leader Acquires the Lifeline of Competitors Cagney left; Anthony Noto arrived—a former Goldman Sachs banker and former CFO of the NFL. He didn’t talk about disruption—he talked about infrastructure. In April 2020, SoFi acquired Galileo for $1.2 billion. Do you know what Galileo is? It’s the back-end engine powering Chime. It’s the foundational layer beneath Robinhood. It’s the payment rail for Revolut, Varo, and TransferWise. A large portion of U.S. fintech transactions run through Galileo’s infrastructure. SoFi bought the company that provided critical infrastructure to its own competitors. You want to disrupt me? First, check whose hands hold your lifeline. At the time, few understood this move. Now, everyone does. That same year, SoFi abandoned the ILC path and instead applied for a full-service, nationally chartered bank license— accepting comprehensive Federal Reserve supervision, stricter capital requirements, and all associated bureaucratic burdens. Voluntarily stepping into the cage—because he knew the cage held something others couldn’t access. ────────── 2021: SPAC Listing, $8.6 Billion Valuation—“Amazon of Finance” In 2021, SoFi merged with a SPAC sponsored by Chamath Palihapitiya, achieving a $8.65 billion valuation. Its stock peaked at $25.78, hailed by the market as the “Amazon of Finance.” Why was the market applauding? Tech-company premium. Not a bank—but a tech platform—so investors assigned high P/E multiples, dream premiums, and bubble valuations. Let me tell you: that assessment was wrong from the start. SoFi has never been a tech company. It’s a company striving to become a bank. And that distinction is enormous. Tech companies build moats with code; banks build moats with charters. Code can be copied; charters cannot. But the market didn’t understand—or perhaps refused to understand—that distinction. During the bubble, no one cared about moats—only about growth curves. ────────── January 18, 2022: That piece of paper—finally secured

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