Abstract
The Present Value Model (PVM) – in which current security prices depend upon the present value of future discounted dividends, where the discount rate is equivalent to the required rate of return – is one of the long-standing principles of Finance Theory. The objective of this work is to analyze the validity of the PVM between prices and dividends at the firm level from panel techniques applied to non-stationary and potentially cointegrated processes for the Brazilian stock market. Considering the Present Value Model with Constant and Time-Varying Expected Returns, the evidence that real (log) prices and real (log) dividends are non-stationary I(1) and (log) price-dividend ratio is I(0) cannot be rejected. Regarding FMOLS and DOLS estimators for panel cointegration models, stock prices are found to be overvalued under either constant or time-varying expected returns assumption.
Highlights
The Present Value Model (PVM) – in which current security prices depend upon the present value of future discounted dividends, where the discount rate is equivalent to the required rate of return – is one of the long-standing principles of Finance Theory
In order to assess the present value model at the firm level for the Brazilian stock market, datasets on prices and dividends have been used at an annual frequency for the period of January 1987 to December 2008
The initial period is based on the availability of data platform, considering that the power of unit root and cointegration tests focuses both on cross sections (N) and, more remarkably, on the extension of the time period considered (T), as evidenced by Shiller and Perron (1985) and Hakkio and Rush (1991)
Summary
The Present Value Model (PVM) – in which current security prices depend upon the present value of future discounted dividends, where the discount rate is equivalent to the required rate of return – is one of the long-standing principles of Finance Theory. Regarding FMOLS and DOLS estimators for panel cointegration models, stock prices are found to be overvalued under either constant or time-varying expected returns assumption. Esting expectations and rationality in financial markets, the Present Value Model (PVM) states that current security prices equals the summed discounted value of future dividends, where the discount rate is equivalent to the required rate of return. As in Campbell and Shiller (1987), real prices and real dividends should cointegrate, i.e. exhibit a stable long-run relationship. In this case, the cointegrating parameter provides an estimate of the inverse discount rate. Campbell and Shiller (1987, 1988), Lee (1995), Sung and Urrutia (1995), Timmermann (1995), and Crowder and Wohar (1998) estimate the present value relation on aggregate level over a significant length of time, in accordance to the concept stated by Stoja and Tucker (2004) that the power of unit root and cointegration tests is based on the length of time period rather than the number of observations
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