TITLE:
Equity Pricing: Perfect Foresight versus Rational Expectations
AUTHORS:
Larry Fogelberg, Chung Baek
KEYWORDS:
Equity Valuation, Rational Expectations, Perfect Foresight, Schumpeterian Event
JOURNAL NAME:
Theoretical Economics Letters,
Vol.8 No.15,
November
26,
2018
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.