Fundamental Valuation of Zero-Dividend Firms
Simon Fraser University Department of Economics Working Paper
26 Pages Posted: 15 Jul 2000
Date Written: June 2000
The calculation of the fundamental price of a zero-dividend firm is accomplished here exploiting the Miller and Modigliani  dividend irrelevance result, the earnings stream of the firm, and an extension of the Donaldson and Kamstra  method of calculating a dividend-paying firm's fundamental price. This extension of Donaldson and Kamstra provides a new methodology for calculating fundamental asset prices when all earnings are retained. The pricing of initial public stock offerings is also accommodated. This method is illustrated by pricing Microsoft stock using only earnings and discount rates. The resulting fundamental forecasts of annual returns to holding Microsoft shares are highly correlated with market returns, with a regression of market returns on fundamental return (out-of-sample) forecasts yielding an r-squared of over 50%, greatly exceeding the performance of conventional valuation methods. This suggests that if an accurate forecast for earnings for the coming year were available, the fundamental model developed here holds the promise of reliable forecasting of price changes, even with the use of a very limited information set.
Keywords: Fundamental asset pricing
JEL Classification: G12
Suggested Citation: Suggested Citation