Abstract
This study demonstrates that when the length of the excess earnings period is not known with certainty, all rational expectations pricing models result in some degree of overpricing when compared ex post facto to perfect foresight models. This study examines the time paths of price under existing valuation models such as Baek et al. [1] and Ohlson and Jeuttner-Nauroth [2] under the following stylized facts: we assume that we are dealing with an all-equity firm with opportunity cost of equity of r, and with a proprietary technology which enables it to achieve a marginal return on equity of R > r for approximately N periods, after which a Schumpeterian event Sis predicted to occurs and the marginal return on equity is expected to revert to the opportunity cost of equity r. Our study demonstrates a deviation of the predicted rational expectations price from the perfect foresight price and demonstrates that such deviation may become extreme near the end of the excess earnings period, resulting in a catastrophic price adjustment when that period comes to an end.
Highlights
In his original formulation of the rational expectations (RE) hypothesis, Muth [3] confined his examination to the special case where: 1) The random disturbances are normally distributed; 2) Certainty equivalents exist for the variables to be predicted; and 3) The equations of the system, including the expectations formulas, are linear
This study examines the time paths of price under existing valuation models such as Baek et al [1] and Ohlson and Jeuttner-Nauroth [2] under the following stylized facts: we assume that we are dealing with an all-equity firm with opportunity cost of equity of r, and with a proprietary technology which enables it to achieve a marginal return on equity of R > r for approximately N periods, after which a Schumpeterian event Sis predicted to occurs and the marginal return on equity is expected to revert to the opportunity cost of equity r
Our study demonstrates a deviation of the predicted rational expectations price from the perfect foresight price and demonstrates that such deviation may become extreme near the end of the excess earnings period, resulting in a catastrophic price adjustment when that period comes to an end
Summary
In his original formulation of the rational expectations (RE) hypothesis, Muth [3] confined his examination to the special case where: 1) The random disturbances are normally distributed; 2) Certainty equivalents exist for the variables to be predicted; and 3) The equations of the system, including the expectations formulas, are linear. Subsequent to the publication of the original Feltham-Ohlson study, a number of studies have supported the assumption there exists some finite excess earnings period during which the firm will enjoy positive NPV opportunities, after which the marginal return on equity will return to the opportunity cost of equity. The theoretical contribution of our study is to show how the predicted rational expectations price deviates from the perfect foresight price with the occurrence of a Schumpeterian event by examining the time paths of price under existing valuation models and demonstrate that such deviation may become extreme near the end of the excess earnings period, resulting in a catastrophic price adjustment when that period comes to an end. After event S, the marginal return on equity reverts to the opportunity cost of equity r
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