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A General Theory of Stock Market Valuation and Return

Christophe Faugere () and Julian Van Erlach
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Julian Van Erlach: Biocosm Inc.

Finance from University Library of Munich, Germany

Abstract: We show that the long-term total market and average investor’s compounded stock returns are determined by GDP growth and are much less than believed because of the infeasible assumption that dividends can be fully reinvested. The long-term stock return closely approximates the return on risk-free debt, thus yielding a zero premium on a compounded per-capita basis. We demonstrate that the market earnings yield ratio (inverse P/E) is akin to a minimum expected return and a direct function of inflation and long-term real GDP per capita growth with marginal regard to risk. Our derived valuation formula is tested against the S&P 500 index and produces a 21% mean percentage tracking error, compared to 32% for the “Fed Model” over the period 1954 – 2002.

Keywords: Required yield; Earnings yield; Equity Premium; S&P 500 Valuation; Fed Model. (search for similar items in EconPapers)
JEL-codes: G12 (search for similar items in EconPapers)
Pages: 34 pages
Date: 2003-11-05, Revised 2004-05-17
New Economics Papers: this item is included in nep-cfn, nep-fin, nep-fmk and nep-rmg
Note: Type of Document - pdf; prepared on Win2000; to print on HP LaserJet 4 plus; pages: 34; figures: Embedded in text. pdf document
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