Fundamental Stock Price with Consumption CAPM and Money Illusion: An International Comparison

What is the fundamental value of a stock? Do stock prices deviate from this fundamental value? If yes, do they go back to their fundamental value? This paper proposes to answer these three questions by using a stock valuation model based on the Consumption-Capital Asset Pricing Model (C-CAPM) with and without money illusion. I first show how to use the C-CAPM to get a fundamental price that can be empirically estimated. This fundamental price is a function of expected future dividends and future consumption, of their future conditional variance and covariance and of agents’ risk aversion. Secondly, I estimate the C-CAPM fundamental price for the United States, the United Kingdom, Japan and Switzerland for a period going from 1965 through to 2006. I identify several periods in which stock pricesdeviate significantly from their fundamental value. Thirdly, I show that after a shock, the gap between the price and its fundamental value decreases with time, which suggests thatstock prices go back to the C-CAPM fundamental value. Finally, I show that forecasts using the C-CAPM fundamental price are more accurate than forecasts based on the observed price only. Additionally, I show that the C-CAPM forecasts systematically outperform forecasts made with other fundamental models (e.g. models based on the price-to-dividend ratios).