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Equity Prices and Fundamentals: a DDM-APT Mixed Approach

Author

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  • Fredj Jawadi

    (EconomiX - EconomiX - UPN - Université Paris Nanterre - CNRS - Centre National de la Recherche Scientifique, UEVE - Université d'Évry-Val-d'Essonne, LITEM - Laboratoire en Innovation, Technologies, Economie et Management (EA 7363) - EESC-GEM Grenoble Ecole de Management - UEVE - Université d'Évry-Val-d'Essonne - TEM - Télécom Ecole de Management)

  • Georges Prat

    (EconomiX - EconomiX - UPN - Université Paris Nanterre - CNRS - Centre National de la Recherche Scientifique)

Abstract

This paper focuses on the linkages between equity prices and fundamentals for 27 individual shares from the French stock price index (CAC40). To assess fundamental value, the traditional Dividend Discount Model (DDM) equities' valuation principle is coupled with the Portfolio Choice Theory based on the Arbitrage Pricing Theory (APT). This yields a general equity valuation relationship for which the APT determines the long-term risk premium included in the DDM. Interestingly, restrictions are less significant than in the usual approaches since the number of risk premium factors is not limited a priori by the theory. Accordingly, our empirical results point to two major findings. On the one hand, while results in the literature based on the DDM showed that fundamental value dynamics are very smooth with respect to stock price indices, our DDM-APT model reproduces both trends and major share price fluctuations. On the other hand, a simple linear Error Correction Model (ECM) highlighted a mean-reversion process of equity prices towards their fundamental values.

Suggested Citation

  • Fredj Jawadi & Georges Prat, 2015. "Equity Prices and Fundamentals: a DDM-APT Mixed Approach," Working paper serie RMT - Grenoble Ecole de Management hal-04141411, HAL.
    • Handle: RePEc:hal:gemwpa:hal-04141411
    Note: View the original document on HAL open archive server: https://hal.science/hal-04141411
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    References listed on IDEAS

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