A General Theory of Stock Market Valuation and Return

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A General Theory of Stock Market Valuation and Return

Author Info

Christophe Faugere (U at Albany)
Julian Van Erlach (Nexxus Financial Technologies)

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Christophe Faugere

Abstract

We show that the long-term total market and average investor's compounded stock returns are determined by GDP growth and are much less than believed because of the infeasible assumption that dividends can be fully reinvested. The long-term stock return closely approximates the return on risk-free debt, thus yielding a zero premium on a compounded per-capita basis. We demonstrate that the market earnings yield ratio (inverse P/E) is akin to a minimum nominal expected return and a direct function of inflation and a real required yield equal to long-term real GDP per capita growth, with marginal regard to risk. Our derived valuation formula is tested against the S&P 500 index and produces a 21% mean percentage tracking error, compared to 32% for the 'Fed Model' over the period 1954 - 2002.

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Paper provided by EconWPA in its series Finance with number 0403004.

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Length: 32 pages
Date of creation: 22 Mar 2004
Date of revision: 17 May 2004
Handle: RePEc:wpa:wuwpfi:0403004

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Paper
- Christophe Faugere & Julian Van Erlach, 2003. "A General Theory of Stock Market Valuation and Return," Finance 0311005, EconWPA, revised 17 May 2004. [Downloadable!]

Find related papers by JEL classification:
G - Financial Economics

This paper has been announced in the following NEP Reports:

NEP-ALL-2004-03-28 (All new papers)
NEP-CFN-2004-03-28 (Corporate Finance)
NEP-FIN-2004-03-28 (Finance)
NEP-FMK-2004-03-28 (Financial Markets)
NEP-RMG-2004-03-28 (Risk Management)

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

Joel Lander & Athanasios Orphanides & Martha Douvogiannis, 1997. "Earnings forecasts and the predictability of stock returns: evidence from trading the S&P," Finance and Economics Discussion Series 1997-6, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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Other versions:
- Eugene F. Fama & Kenneth R. French, . "Forecasting Profitability and Earnings," CRSP working papers 358, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
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Other versions:
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Eugene F. Fama & Kenneth R. French, 2002. "The Equity Premium," Journal of Finance, American Finance Association, vol. 57(2), pages 637-659, 04. [Downloadable!] (restricted)
Other versions:
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Other versions:
- Steven A. Sharpe, 2002. "Reexamining Stock Valuation and Inflation: The Implications Of Analysts' Earnings Forecasts," The Review of Economics and Statistics, MIT Press, vol. 84(4), pages 632-648, 06. [Downloadable!] (restricted)
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- Pritchett, Lant, 1995. "Divergence, big time," Policy Research Working Paper Series 1522, The World Bank. [Downloadable!]
Shiller, Robert J, 1981. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," American Economic Review, American Economic Association, vol. 71(3), pages 421-36, June. [Downloadable!] (restricted)
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Rajnish Mehra, 2003. "The Equity Premium: Why is it a Puzzle?," NBER Working Papers 9512, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)

Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

Christophe Faugere & Julian Van Erlach, 2004. "The Price of Gold: A Global Required Yield Theory," Finance 0403003, EconWPA. [Downloadable!]

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