Equity Pricing: Perfect Foresight versus Rational Expectations

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 S is 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.