55 Pages Posted: 3 Mar 1997
Date Written: January 17, 1997
We use a residual income valuation model to compute a measure of the intrinsic value for the 30 stocks in the DJIA. As a departure from the current literature, we do not require price to equal intrinsic value at all times. Rather, we model the time-series relation between price and value as a co-integrated system, so that price and value are long-term convergent. In this framework, we show that superior empirical estimates of value will not only track price more closely, but also be better predictors of subsequent returns. We find that since 1978, traditional indicators of market value (e.g., B/P, E/P, and D/P) have had little predictive power for subsequent returns. In contrast, a V/P ratio based on the residual income model reliably predicts overall market returns over as short a time interval as one- month. Using a VAR simulation technique, we find this result is robust when we include B/P, D/P, and E/P in the regression, and continues to hold when we control for the ex ante default risk premium and term structure risk premium. Further analyses show both time-varying discount rates and forward-looking earnings information are important to the success of V/P.
JEL Classification: G10
Suggested Citation: Suggested Citation
Lee, Charles M.C. and Myers, James N. and Swaminathan, Bhaskaran, What is the Intrinsic Value of the Dow? (January 17, 1997). Available at SSRN: https://ssrn.com/abstract=376 or http://dx.doi.org/10.2139/ssrn.376
By S.p. Kothari