What is the Intrinsic Value of the Dow?

Authors

  • Charles M. C. Lee,

    1. Johnson Graduate School of Management, Cornell University
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  • James Myers,

    1. University of Washington
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  • Bhaskaran Swaminathan

    1. Johnson Graduate School of Management, Cornell University
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    • Lee and Swaminathan are at the Johnson Graduate School of Management, Cornell University. Myers is at the University of Washington. We appreciate the helpful comments from Bill Beaver, Peter Easton, Jim Ohlson, Stephen Penman, Jay Ritter, Terry Shevlin, Robert Shiller, René Stulz (editor), Dan Thornton, an anonymous referee, and workshop participants at the University of Chicago, Cornell University, Dartmouth College, the University of Florida, N.B.E.R. Behavioral Finance Workshop, the London Business School, the Massachusetts Institute of Technology, Northwestern University, Stanford University, the University of Utah, the University of Washington, and the 1997 Western Finance Association. Ken French kindly provided the industrial portfolio and the factor portfolio returns. Financial analyst earnings forecasts were obtained from I/B/E/S Inc. Some of this work was completed during Lee's tenure as 1995–96 Visiting Economist at the New York Stock Exchange.

Abstract

We model the time-series relation between price and intrinsic value as a cointegrated system, so that price and value are long-term convergent. In this framework, we compare the performance of alternative estimates of intrinsic value for the Dow 30 stocks. During 1963–1996, traditional market multiples (e.g., B/P, E/P, and D/P ratios) have little predictive power. However, a V/P ratio, where V is based on a residual income valuation model, has statistically reliable predictive power. Further analysis shows time-varying interest rates and analyst forecasts are important to the success of V. Alternative forecast horizons and risk premia are less important.

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