Stock Valuation in Dynamic Economics

52 Pages Posted: 12 Jun 2001

See all articles by Zhiwu Chen

Zhiwu Chen

University of Hong Kong; Yale University - International Center for Finance; Zebra Capital Management, LLC

Gurdip Bakshi

Fox School of Business

Date Written: May 29, 2001

Abstract

This article develops and empirically implements a stock valuation model. The model makes three assumptions: (i) dividend equals a fixed fraction of net earnings-per-share plus noise; (ii) the economy's pricing kernel is consistent with the Vasicek term structure of interest rates; and (iii) the expected earnings growth rate follows a mean-reverting stochastic process. Our parameterization of the earnings process distinguishes long-run earnings growth from current growth and separately measures the characteristics of the firm's business cycle. The resulting stock valuation formula has three variables as input: net earnings-per-share, expected earnings growth and interest rate. Using a sample of individual stocks, our empirical exercise leads to the following conclusions: (1) the derived valuation formula produces significantly lower pricing errors than existing models both in-and out-of-sample; (2) modeling earnings growth dynamics properly is the most crucial for achieving better performance, while modeling the discounting dynamics properly also makes a significant difference; (3) our model's pricing errors are highly persistent over time and correlated across stocks, suggesting the existence of factors that are important in the market's valuation but missing from our model. In addition to pricing stocks, we can apply the model to back out market expectations about the firm's future from its stock price, allowing us to recover the relevant information embedded in the stock price.

JEL Classification: G10, G12, G13

Suggested Citation

Chen, Zhiwu and Bakshi, Gurdip S., Stock Valuation in Dynamic Economics (May 29, 2001). Yale ICF Working Paper No. 00-36. Available at SSRN: https://ssrn.com/abstract=273048 or http://dx.doi.org/10.2139/ssrn.273048

Zhiwu Chen (Contact Author)

University of Hong Kong ( email )

Pokfulam Road
Hong Kong
China

Yale University - International Center for Finance ( email )

Box 208200
New Haven, CT 06520-8200
United States
203-432-5948 (Phone)
203-432-6970 (Fax)

Zebra Capital Management, LLC ( email )

612 Wheelers Farms Road
Milford, CT 06461
United States

Gurdip S. Bakshi

Fox School of Business ( email )

Department of Finance
Philadelphia, PA 19022
United States
215-204-6117 (Phone)
tuk40718@temple.edu (Fax)

HOME PAGE: http://https://sites.google.com/view/gurdipbakshi1

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