Corporate Earnings and the Equity Premium

Abstract

Corporate cash flows are highly volatile and strongly procyclical. We examine the asset-pricing implications of the sensitivity of corporate cash flows to economic shocks within a continuous-time model in which dividends are a stochastic fraction of aggregate consumption. We provide closed-form solutions for stock values and show that the equity premium can be represented as the sum of three components which we call the consumption-risk, event-risk, and corporate-risk premia. Calibrating to historical data, we show that the model implies a total equity premium many times larger than in the standard model. The model also generates levels of equity volatility consistent with those experienced in the stock market.