The Determinations of Equity Value with Stochastic Term Structure of Discount Factors

Abstract

This paper discusses equity valuation on a per share basis and in a stochastic term structure of discount factors framework. The value of equity has been explicitly expressed in a no-growth component, which is proxied by either capitalised next period earnings or open book value, and growth components, which links short term performance of book value and growth rates of earnings performance adjusted by market systematic risk. Consistent with asset pricing theory discounting risk-adjusted future cash stream bases on short term interest rate rather than risk-adjusted cost of capital. The growth value is shown to be a function of retention rate and persistence of returns on earnings retained and the market risk. The constant dividend growth model and Ohlson and Juettner (2000) are special cases if one assumes that the interest rate is constant and the future investment opportunities have the same risk as the existing business. In a constant earnings growth setting, it is shown that only when return on equity is greater than a risk adjusted rate of return should the firm increase the retention rate, and the implied risk premium is positively linked to the systematic market risk in a nonlinear fashion.