Valuing Equities: Discounting Growth Opportunities, Fearing Inflation

36 Pages Posted: 18 Mar 2019

Date Written: March 8, 2019

Abstract

Over the last century (Eretained/P)mean ~ constant while D/P has experienced a long secular decline. If investors cannot simultaneously discount both Eretained and D, examination of the relationships between Eretained/P, D/P and the payoff ratio Eretained/D offers support to the hypothesis that Eretained/P is the priced valuation ratio. A linear Empirical Model (EM) identifies two data variables, the trailing earnings growth (EG) and inflation (cpi), that explain R2 ~ 50% of the variance of Eretained/P. The investor’s decision to sell or hold the shares is governed by the investor’s resistance to Intertemporal Substitution, R = γµ, so the MF-Gordon becomes Eretained/P = γµ - µ . A dynamic Model is obtained using Taylor expansions of the functional relationships µ = µ(EG(t)) and γ = γ(cpi(t)). The Model is calibrated using the EM. The MF-Gordon Model is used to explain the quasi-equality of equities and the long bond (1970:2000), the equity/long bond equity premium and the effect of sentiment on equity prices. The Shiller price volatility puzzle is explained by the adaptive growth expectation which is heavily loaded on the highly volatile trailing earnings growth rate.

Keywords: Asset Pricing, Resistance to Inter-Temporal Substitution, Real Return, Micro-Foundation, Risk Aversion, Inflation Puzzle, Money Illusion, Price Volatility, Equity Risk Premium, Equity Valuation, Gordon Model, C-CAPM

JEL Classification: G4, G12

Suggested Citation

Blanken, Ronald, Valuing Equities: Discounting Growth Opportunities, Fearing Inflation (March 8, 2019). Available at SSRN: https://ssrn.com/abstract=3349429 or http://dx.doi.org/10.2139/ssrn.3349429

Ronald Blanken (Contact Author)

Sci2Tech, Inc. ( email )

United States

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