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Equity Prices and Fundamentals: a DDM-APT Mixed Approach

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  • Fredj Jawadi
  • Georges Prat

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," EconomiX Working Papers 2015-16, University of Paris Nanterre, EconomiX.
  • Handle: RePEc:drm:wpaper:2015-16
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    References listed on IDEAS

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    More about this item

    Keywords

    Stock valuation; equity risk premium; stock price adjustment.;

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes

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