Fundamental Valuation of Equities under Allocative Rationality

We estimate the fundamental values of individual stocks under the allocative rationality hypothesis, according to which portfolio diversification implies a valuation process in which only non-diversifiable risk is rewarded to investors. This new modeling approach, which departs from the rational expectations hypothesis, is applied to 33 companies selected from the 11 economic sectors of the S&P500 index. For each company, the dividend growth model (DGM) is combined with arbitrage pricing theory (APT), linking the equity risk premium to common factors through specific sensitivities. The estimation of our multivariate DGM-APT model over the period November 1983 to September 2024 leads to the identification of five common factors: the market factor, the default spread of interest rates, the oil price, the inflation rate, and the real GDP growth rate. To this end, we employ a methodology that is robust to parameter instability - marked by a common structural break in August 1995 - and which addresses residual autocorrelation through the use of bootstrap techniques. Our results differ from previous studies, which conclude that the fundamental values of stock indices are smoother than observed indices, a phenomenon known as the volatility puzzle. This puzzle disappears within our firm-level DGM-APT framework, in which fundamental values capture stock price trends and account for a large share of short-term fluctuations. However, consistent with studies based on indices, we highlight a mean-reversion process of stock prices toward their fundamentals.