17 Session 8: What a Correct Theory Must Deliver
| Unit | 2 — Measurement and Theory |
| Book Chapter | 5 (all sections) |
| Track | Common core (both tracks) |
| Assessment milestone | PS1 due (start of class) |
17.1 Learning Objectives
By the end of this session, students will be able to:
- State the five requirements a correct private market valuation theory must satisfy.
- Evaluate alternative frameworks (DCF, DLOM, factor models, GE-LAV) against these five requirements.
- Articulate why no framework prior to GE-LAV satisfies all five simultaneously.
- Connect Unit 1 (why DCF fails) and Unit 2 (measurement problems) to Unit 3 (the GE-LAV alternative).
- Identify the five main results of GE-LAV by name and recognize them when encountered.
17.2 Pre-Class Assignment
- Read: Book Chapter 5, all sections (~10 pages — short chapter)
- Submit: PS1 (due at start of class)
17.3 In-Class Outline (75 minutes)
| Time | Segment | Format |
|---|---|---|
| 0:00–0:05 | PS1 collection · Recap Sessions 1–7 | Logistics + Lecture |
| 0:05–0:15 | Why we need a theory, not just better metrics | Lecture |
| 0:15–0:45 | The five requirements of a correct theory | Lecture (one slide per requirement) |
| 0:45–1:00 | Evaluating alternatives against the five requirements | Lecture + comparison table |
| 1:00–1:10 | The GE-LAV model at a glance | Lecture |
| 1:10–1:15 | Bridge to Session 9 (Midterm review) and Unit 3 | Lecture + Q&A |
17.4 Discussion Questions
- Of the five requirements, which do you think is most controversial within the practitioner community? Which is most controversial within the academic community? Why might they differ?
- The Pastor-Stambaugh liquidity factor satisfies “stochastic premia” but fails “endogenous market clearing.” Does that matter for using it as a factor in a portfolio? When?
- If GE-LAV becomes the regulatory standard for private market valuation, what new operational burdens does it impose on a typical PE fund GP? How would you mitigate those?
17.5 Worked Conceptual Example: Evaluating a New Framework
Setup: Suppose a new valuation method is proposed called “Adaptive DCF” — it uses a different discount rate depending on which of four manually-defined regimes the analyst declares the market to be in.
Evaluation against the five requirements:
- Stochastic? Partial. Discount rate varies across regimes, but not within. No process model.
- Heterogeneous? No. Same regime classification for all investors.
- Endogenous? No. Regime is exogenously declared, not equilibrium-determined.
- Implementable? Yes. Easy to implement; analyst judgment-based.
- Welfare? No. No mechanism for welfare analysis or regulatory correction.
Conclusion: Adaptive DCF is an improvement over constant-premium DCF but doesn’t satisfy requirements 2, 3, or 5. It would be acceptable as a transition methodology but not as a long-term framework.
17.6 What to Expect Next Session
Session 9 is Midterm Review. Format:
- 30 minutes: synthesis lecture covering Sessions 1–8
- 30 minutes: worked examples of all four question types from the midterm
- 15 minutes: Q&A — bring questions
The midterm is Session 10. Bring: pencil, pen, eraser, calculator, formula sheet (handwritten, double-sided, 8.5×11”), ID.
Reading: No new reading. Review Sessions 1–8 lecture notes and book Chapters 1–5.
Suggested study sequence: 1. Re-read book Ch. 1 (the conceptual core) 2. Work all PS1 questions one more time 3. Make your formula sheet before the review session — bring it to Session 9 to check 4. Sample exam questions from midterm blueprint