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Stock Valuation in Dynamic Economics

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  • Zhiwu Chen
  • Gurdip Bakshi

Abstract

This article develops and empirically implements a stock valuation model. The model makes three assumptions: (i) dividend equals a fixed fraction of net earnings-per-share plus noise; (ii) the economy's pricing kernel is consistent with the Vasicek term structure of interest rates; and (iii) the expected earnings growth rate follows a mean-reverting stochastic process. Our parameterization of the earnings process distinguishes long-run earnings growth from current growth and separately measures the characteristics of the firm's business cycle. The resulting stock valuation formula has three variables as input: net earnings-per-share, expected earnings growth and interest rate. Using a sample of individual stocks, our empirical exercise leads to the following conclusions: (1) the derived valuation formula produces significantly lower pricing errors than existing models both in-and out-of-sample; (2) modeling earnings growth dynamics properly is the most crucial for achieving better performance, while modeling the discounting dynamics properly also makes a significant difference; (3) our model's pricing errors are highly persistent over time and correlated across stocks, suggesting the existence of factors that are important in the market's

Suggested Citation

  • Zhiwu Chen & Gurdip Bakshi, 2001. "Stock Valuation in Dynamic Economics," Yale School of Management Working Papers ysm198, Yale School of Management.
    • Handle: RePEc:ysm:wpaper:ysm198
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    File URL: https://repec.som.yale.edu/icfpub/publications/2541.pdf
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    Cited by:

    1. Andrew Ang & Jun Liu, 2003. "How to Discount Cashflows with Time-Varying Expected Returns," NBER Working Papers 10042, National Bureau of Economic Research, Inc.

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