Equity prices and fundamentals: a DDM–APT mixed approach

This paper focuses on the linkage between equity prices and fundamentals for 27 individual shares belonging to the French stock price index (CAC40). To assess fundamental value, the traditional dividend discount model (DDM) is coupled with the arbitrage pricing theory (APT), which assumes that investors hold efficient portfolios. This yields a simple equity valuation relationship for which the APT determines the long-term risk premium included in the DDM. Accordingly, equity risk premia are determined by common factors reflecting the non diversifiable risk. These factors are not a priori identified by the theory, and therefore must be exhibited through an empirical analysis. Four domestic and three international common factors are found, all being among those identified by empirical analyses of the APT in the literature. While studies related to stock price indices showed that DDM fundamental values are very smooth compared to stock indices, our DDM–APT model reproduces both trends and major fluctuations of share prices. Further, as for studies based on stock indices, a mean-reverting process of equity prices towards fundamentals is highlighted, but the linear error correction model that was considered contains shortcomings suggesting a more complex adjustment process.