Common Stock Valuation: A Gulf Between Theory and Practice

Abstract

The theoretical valuation model has been shown to be mathematically equivalent to a price-earnings approach to stock valuation. The theoretical model explicitly includes estimates of long-run dividend (or earnings) growth. Because the price-earnings ratio approach is equivalent, it also implicitly requires estimates of long-run earnings growth. Thus, an expected future price-earnings ratio (however derived) is a surrogate for forecasting earnings growth into the indefinite future.

To the extent individuals employ the price-earnings approach to common stock valuation, they are implicitly applying the theoretical valuation model. This is true whether or not they are fully aware of the implicit assumptions of the price-earnings ratio approach. To the extent they are aware of these assumptions, the gulf between theory and practice is more semantic than conceptual. In both valuation approaches equally, investment success in the short-run (and the long-run for that matter) depends on the ability to make relatively accurate long-run forecasts.