Why is the Cobb Douglas function under the Equity Valuation Methods section?

[JSobes]

I’m just going through econ after my 2013 AM/PM test taking and the cobb production function is the first thing we learn for developing CME in Equity Market Valuation. Isn’t this something applicable to the entire economy? Development levels and economy size determine liquidity in both equity and fixed income securities markets so why is it here? Am I missing something?

 

[Carlo]

Yes, the Cobb-Douglas is relevant for the entire economy.
As a matter of fact you can find the Cobb-Douglas (in disguise) also in the opening reading about CME (Reading 16).
In section 4.2.2 where they talk about “Decomposition of GDP growth…” they clearly use the Cobb Douglas although they don’t say it in so many words.
Good luck, Carlo

 

[ink]

You’re developing capital market expectations, which relates to fidning what your systematic risk exposures are. Cobb-Douglas is used to find the rate of growth in the economy, which relates to the rate of growth in equity. When you do top-down research, you basically have to have some estimates about what the rate of growth for a particular equity index might be. For instance, if you want to predict how well stocks will perform in the long run in China, you can start building your estimate around what the economic growth in China might be and then go from there.

 

[OMGMileyCyrus]

The first few pages (pages 123-124) of Reading 17 Equity Market Valuation of the CFAI text make reference to the use of the Cobb Douglas production to obtain growth rates for the economy which can be used to determine the dividend growth rate trajectory for equity markets. A lot of the formulas that we use in equity valuation, such as the Gordon Constant Growth Model and the multi-period growth (H-model), rely on some measurement of growth rate of dividends and growth rate of the economy to determine our initial value today, Vo.