Under/over-valuation of the stock market and cyclically adjusted earnings
AbstractThe ratio between current earnings per share and share price (the EP ratio) is widely considered to be an effective gauge of under/over-valuation of a corporation’s stock. Arguably, a more reliable indicator (the cyclically-adjusted EP ratio) can be obtained by replacing current earnings with a measure of ‘permanent earnings’, i.e. the profits that the corporation is able to earn, on average, over the medium to long run. I propose a state-space model to filter business-cycle oscillations out of current earnings and compute the cyclically-adjusted EP ratio. I estimate the model with euro-area aggregate stock market data. I find periods, notably around the 2008 financial crisis, when the adjusted and the unadjusted EP ratios provide economically and statistically different indications. I propose a method to make the adjusted EP ratio easier to interpret by translating its values into estimates of the probability that the stock market is under/over-valued. These estimates clearly indicate periods of mis-valuation in my sample. Furthermore, some simulations suggest that the model would have been able to provide early warning signs of mis-valuation in real time.
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Bibliographic InfoPaper provided by Bank of Italy, Economic Research and International Relations Area in its series Temi di discussione (Economic working papers) with number 780.
Date of creation: Dec 2010
Date of revision:
earnings/price ratio; cyclically adjusted earnings; undervaluation/overvaluation of stocks;
Other versions of this item:
- Marco Taboga, 2011. "Under‐/Over‐Valuation of the Stock Market and Cyclically Adjusted Earnings," International Finance, Wiley Blackwell, vol. 14(1), pages 135-164, 04.
- G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
- C46 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - Specific Distributions
This paper has been announced in the following NEP Reports:
- NEP-ALL-2010-12-18 (All new papers)
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