Modeling Growth Stocks Via Size Distribution

Abstract

The inability to predict the earnings of growth stocks, such as biotechnology and internet stocks, leads to the high volatility of share prices and difficulty in applying the traditional valuation methods. This paper attempts to demonstrate that the high volatility of share prices can nevertheless be used in building a model that leads to a particular size distribution, which can then be applied to price a growth stock relative to its peers. The model focuses on both transient and steady state behavior of the market capitalization of the stock, which in turn is modeled as a birth-death process. In addition, the model gives an explanation to an empirical observation that the market capitalization of internet stocks tends to be a power function of their relative ranks.

Keywords: biotechnology and internet stocks, asset pricing, birth-death process, convergence rate, power-type distribution, regression.

JEL Classification: G12, C19