An Equity Market Model and its Implications

Abstract:     
We derive a simple model of the market - an equation for investor return as a function of four variables. The model defines optimal dividend, investment, and share repurchase policy. The model confirms Tobin's proposition that the equilibrium market value of equity assets should equal the current cost of those assets. The model also predicts that the ratio of investor return to earnings yield should revert to an equilibrium value of one. Analysis of 133 years of aggregate market data supports this prediction, and confirms a definition of equity in q theory that does not include intangibles.

Number of Pages in PDF File: 34

Keywords: Tobin's q, market model, investor return, earnings yield, equilibrium market model, investment policy, return prediction, market valuation, dividend policy, equity intangibles, equity premium, Gordon dividend growth model, Shiller data, Federal Reserve non-farm non-financial data, price speculation

JEL Classification: C20, C22, C68, D50, D46, G12, G31, G35

working papers series