Summary

The foundation of equity pricing is also a discounted cash flow model. Unlike bonds, however, equity cash flows have inherent uncertainty (these are not contractual cash flows as are coupons) and the discount rate is not an internal rate of return. Instead, the discount rate is the rate that satisfies the Euler relation between the marginal utilities of present and future consumption. Thus, we extend the development of the discount rate developed through the first three chapters to a fundamental model that motivates the discount rate as the solution to optimizing utility in an intertemporal consumption problem.

The Euler relation is a subtle reminder of the role of behavioral economics in pricing models. We therefore lay some groundwork anticipating departures from rationality, which we develop more fully in Chapter 8 on anomalies. We also introduce some simple models of trend extrapolation and its weaknesses, perhaps signaling that simple extrapolative heuristics may suggest that agents are not fully rational and that, possibly, departures from fundamentals may persist. But, the major contribution is once again the notion that agents price assets by evaluating the sum of their discounted expected cash flows. The dividend discount model and the Gordon Growth model are important developments in the evolution of equity pricing models. These models are driven by fundamentals—earnings and discount rates—while extrapolative trend models appeal not to fundamentals, but to univariate models based on historical trend analysis that implicitly rely on rather restrictive assumptions about what the true equilibrium return should be. I argue instead that while extrapolative models may be useful gauges of performance, they do not rely on fundamentals and are therefore not informative. I then introduce a structural model of earnings that is tied to macroeconomic factors that helps explain how earnings respond to changes in the underlying economy. This was a VAR regression model that also has the property of mean reversion and could be useful as a long-run forecasting model.

It should be obvious that these models together produce a wide range of return forecasts. None of them forecasted the exceptional earnings growth that the economy experienced in 2009 and that is stark evidence on the state of the art in equity return forecasting.