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Stock valuation in dynamic economies

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  • Bakshi, Gurdip
  • Chen, Zhiwu

Abstract

This article develops and empirically implements a stock valuation model. The model makes three assumptions: (i) dividend equals a fixed fraction of net earnings-per-share plus noise; (ii) the economy's pricing kernel is consistent with the Vasicek term structure of interest rates; and (iii) the expected earnings growth rate follows a mean-reverting stochastic process. Our parameterization of the earnings process distinguishes long-run earnings growth from current growth and separately measures the characteristics of the firm's business cycle. The resulting stock valuation formula has three variables as input: net earnings-per-share, expected earnings growth and interest rate. Using a sample of individual stocks, our empirical exercise leads to the following conclusions: (1) the derived valuation formula produces significantly lower pricing errors than existing models both in-and out-of-sample; (2) modeling earnings growth dynamics properly is the most crucial for achieving better performance, while modeling the discounting dynamics properly also makes a significant difference; (3) our model's pricing errors are highly persistent over time and correlated across stocks, suggesting the existence of factors that are important in the market's
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  • Bakshi, Gurdip & Chen, Zhiwu, 2005. "Stock valuation in dynamic economies," Journal of Financial Markets, Elsevier, vol. 8(2), pages 111-151, May.
    • Handle: RePEc:eee:finmar:v:8:y:2005:i:2:p:111-151
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