Unexpected, Yet True, Value Maximization Is a Rational Behavioral, as Opposed to Rational Expectations Valuation Rubric

Abstract

This study provides formal theoretical evidence that value maximization is a rational behavioral, as opposed to rational expectations valuation rubric. Rational behavioral character of the value maximization rubric is evident in the axiomatic finding that, absent arrival of any unanticipated perturbations to pre-existing equilibriums, the value maximization rubric is significantly more likely to generate price drifts that are negative. In absence of any unanticipated perturbations then, investments in stock markets have character of preferences over lotteries. On the contrary, stock valuations that are arrived at in context of Pareto optimality of firms' investment allocations (`Pareto optimality') are shown to conform with rational expectations equilibriums. Under assumption of non-arrival of any unanticipated perturbations to pre-existing equilibriums, stock valuations arrived at in context of Pareto optimality always generate positive price drift. Totality of study findings provide evidence that stock markets function less as preferences over lotteries if parameterization of stock prices is transitioned from the value maximization rubric to the Pareto optimality rubric. In this respect, it is noteworthy that the workhorse Gordon Growth Model can produce stock valuations that are adapted to either of the Pareto optimality, or value maximization rubrics. It is normative then that there exists demand for an addendum to the Gordon Growth model, an addendum, which mitigates arrival at stock valuations that conform with rational behavioral, as opposed rational expectations equilibriums.

Keywords: Pareto Optimality, Value Maximization, Valuation, Stock Prices, True Equilibriums, Price Drift, Rational Expectations, Rational Behaviors

JEL Classification: G14, D52, D53