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Under/over-valuation of the stock market and cyclically adjusted earnings

Author

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  • Marco Taboga

    (Bank of Italy)

Abstract

The ratio between current earnings per share and share price (the EP ratio) is widely considered to be an effective gauge of under/over-valuation of a corporation�s stock. Arguably, a more reliable indicator (the cyclically-adjusted EP ratio) can be obtained by replacing current earnings with a measure of �permanent earnings�, i.e. the profits that the corporation is able to earn, on average, over the medium to long run. I propose a state-space model to filter business-cycle oscillations out of current earnings and compute the cyclically-adjusted EP ratio. I estimate the model with euro-area aggregate stock market data. I find periods, notably around the 2008 financial crisis, when the adjusted and the unadjusted EP ratios provide economically and statistically different indications. I propose a method to make the adjusted EP ratio easier to interpret by translating its values into estimates of the probability that the stock market is under/over-valued. These estimates clearly indicate periods of mis-valuation in my sample. Furthermore, some simulations suggest that the model would have been able to provide early warning signs of mis-valuation in real time.

Suggested Citation

  • Marco Taboga, 2010. "Under/over-valuation of the stock market and cyclically adjusted earnings," Temi di discussione (Economic working papers) 780, Bank of Italy, Economic Research and International Relations Area.
    • Handle: RePEc:bdi:wptemi:td_780_10
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    References listed on IDEAS

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    1. van Norden, Simon, 1996. "Regime Switching as a Test for Exchange Rate Bubbles," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 11(3), pages 219-251, May-June.
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    Cited by:

    1. Sara Cecchetti & Marco Taboga, 2017. "Assessing the risks of asset overvaluation: models and challenges," Temi di discussione (Economic working papers) 1114, Bank of Italy, Economic Research and International Relations Area.
    2. Guido de Blasio & Davide Fantino & Guido Pellegrini, 2015. "Evaluating the impact of innovation incentives: evidence from an unexpected shortage of funds," Industrial and Corporate Change, Oxford University Press and the Associazione ICC, vol. 24(6), pages 1285-1314.
    3. Hudepohl, Tom & van Lamoen, Ryan & de Vette, Nander, 2021. "Quantitative easing and exuberance in stock markets: Evidence from the euro area," Journal of International Money and Finance, Elsevier, vol. 118(C).

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    More about this item

    Keywords

    earnings/price ratio; cyclically adjusted earnings; undervaluation/overvaluation of stocks;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • C46 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - Specific Distributions

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