A Dynamic Model of Firm Valuation

We propose a dynamic version of the dividend discount model, solve it in closed-form, and assess its empirical validity. The valuation method is tractable and can be easily implemented. We find that our model produces equity value forecasts that are very close to market prices, and explains a large proportion (around 83%) of the observed variation in share prices. Moreover, we show that a simple portfolio strategy based on the difference between market and estimated values earns considerably positive returns. These returns are uncorrelated with the three risk factors in Fama and French (1993).Center for Analytical Finance (CAFIN