DETERMINANTS OF COMMON STOCK PRICES*

Abstract

THE NEED FOR A VIABLE THEORY of common stock value has been highlighted in recent years both by the questionable performance of the professional investor and by the development of a theory of corporate financial management based on thS maximization of wealth. The purpose of this study was to see to what extent a model, based on the way a rational stockholder might value common stock and employing only historical data, could explain stock prices. The first step in the development of the model was to postulate those broad economic influences which affect the value of a share of stock. The price of a share of stock should be equal to the present value of a stream of future benefits discounted at a rate which reflects both the stockholder's time preference and his perception of and attitude toward risk. The benefits which the should consider are future dividends: while risk and uncertainty and, hence, the discount rate should be functions of the operating characteristics of the firm, its financial structure, its size, and the time path of dividends as viewed by the prospective shareholder. A stock-pricing model was constructed in terms of these five explanatory variables. Since the performance of a model is dependent upon the definition of each of its component parts, a major section of the dissertation was devoted to the formulation and testing of alternative measures of each of the variables contained in the model. The selection of variable definitions, which was performed on both theoretical and empirical grounds, produced insight into the way in which the evaluates financial data. For example, in examining measures of financial structure, an attempt was made to differentiate between the effects of preferred stock and bonds on share price, and preferred stock was found to have the much larger effect. In addition, examination of alternative definitions for each variable revealed that many previous empirical studies of stock prices and cost of capital used independent variables which were themselves functions of the dependent variable. This introduced bias into the results and may have accounted for several cases where the influence of an independent variable appeared to be opposite to that which theory would lead us to infer. After selecting a subset of variable definitions, the model was tested using crosssectional multiple regression analysis on 59 stocks in a group of closely related industries for each of thirteen years (1951-63). The results appeared quite promising. The model was successful in explaining an average of 87.95% of the variation in yearly stock prices over the entire period, and at no time did it explain less than 81 % of the difference in yearly stock prices. Furthermore, the individual regression coefficients took on the sign postulated by the theory in every case tested. This performance suggests that the overall model and the specific definition of each variable are useful tools for the financial analyst. Having established that the model performs well in explaining differences in market price at several points in time, an attempt was made to see to what extent changes