Intrinsic Bubbles in Stock Prices Under Persistent Dividend Growth Rates

35 Pages Posted: 15 Feb 2019 Last revised: 31 Mar 2019

See all articles by Faisal M. Awwal

Faisal M. Awwal

Southeast Toyota Finance (SETF) - Data & Analytics

Prasad V. Bidarkota

Florida International University (FIU) - Department of Economics

Date Written: March 24, 2019

Abstract

We extend the constant discount factor model with intrinsic bubbles developed in Froot and Obstfeld (1991) to account for serial correlation in dividend growth rates. We derive an exact analytical expression for both the present value stock price and an intrinsic bubble component when dividend growth rates evolve as a Gaussian first-order autoregressive process. We estimate the model with two sets of annual U.S. stock prices and dividends data, namely the DJIA and the S&P 500 series, over the last century. Hypotheses tests reject an AR(0) process for dividend growth rates in favor of an AR(1) process for both data series. Likelihood ratio tests also favor the AR(1)-based model developed here for price-dividends ratios to the AR(0)-based model considered in Froot and Obstfeld (1991). Hypotheses tests also reject the absence of a bubble component in both series. This inference is robust to whether or not the parameters governing the intrinsic bubbles process are restricted to values implied by our model or freely estimated. Incorporating the bubble component into our model provides a significant improvement in fit to observed P/D ratios and stock prices as compared to the present value stock prices alone.

Keywords: Stock Prices, Price-Dividend Ratios, Present-Value Model, Intrinsic Bubbles, Closed-Form Solutions

JEL Classification: C12, G10, G12

Suggested Citation

Awwal, Faisal M. and Bidarkota, Prasad V., Intrinsic Bubbles in Stock Prices Under Persistent Dividend Growth Rates (March 24, 2019). Available at SSRN: https://ssrn.com/abstract=3320234 or http://dx.doi.org/10.2139/ssrn.3320234

Faisal M. Awwal (Contact Author)

Southeast Toyota Finance (SETF) - Data & Analytics ( email )

100 Jim Moran Blvd
Deerfield Beach, FL 33442
United States

Prasad V. Bidarkota

Florida International University (FIU) - Department of Economics ( email )

University Park, DM 320A
Florida International University
Miami, FL 33199
United States
305-348-6362 (Phone)
305-348-1524 (Fax)

HOME PAGE: http://www.fiu.edu/~bidarkot/

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