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What is the Intrinsic Value of the Dow?
Charles M.C. Lee Barclays Global Investors - Advanced Strategies and Research James N. Myers University of Arkansas B. Swaminathan LSV Asset Management; Johnson Graduate School of Management January 17, 1997 Abstract: We use a residual income valuation model to compute a measure of the intrinsic value for the 30 stocks in the DJIA. As a departure from the current literature, we do not require price to equal intrinsic value at all times. Rather, we model the time-series relation between price and value as a co-integrated system, so that price and value are long-term convergent. In this framework, we show that superior empirical estimates of value will not only track price more closely, but also be better predictors of subsequent returns. We find that since 1978, traditional indicators of market value (e.g., B/P, E/P, and D/P) have had little predictive power for subsequent returns. In contrast, a V/P ratio based on the residual income model reliably predicts overall market returns over as short a time interval as one- month. Using a VAR simulation technique, we find this result is robust when we include B/P, D/P, and E/P in the regression, and continues to hold when we control for the ex ante default risk premium and term structure risk premium. Further analyses show both time-varying discount rates and forward-looking earnings information are important to the success of V/P.
JEL Classifications: G10 Working Paper SeriesDate posted: March 03, 1997 ; Last revised: November 05, 1997Suggested CitationContact Information
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