Stock valuation in dynamic economies

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. The resulting stock valuation formula has three variables as input: net earnings-per-share, expected earnings growth, and interest rate. Using a sample of stocks, our empirical exercise shows that the derived valuation formula produces significantly lower pricing errors than existing models, both in- and out-of-sample. Modeling earnings growth dynamics properly is the most crucial for achieving better performance, while modeling the discounting dynamics properly also makes a significant difference.