DEFINING THE ROLE AND ESTIMATION OF THE DISCOUNT FACTOR IN A SECURITY VALUATION MODEL

In this paper we show that a striking improvement in the explanatory power of a “dividend type” of security valuation model can be obtained by classifying companies into equivalent risk categories, estimating the discount factor for a category, and then constructing a cross-sectional model for it. The increased homogenity of the data base improves the model's sensitivity to systematic forces, but does not sacrifice the heterogeneity of the independent variables. Assuming that the difference between the intrinsic value of a security and its market value should be zero, the authors demonstrate a method for estimating k_jt, the market discount rate for the j^th risk category in the t^th period. The results of the estimation procedure appear to be reasonable and when used in our security valuation model they produce higher coefficients of determination (R²) than those previously published for similar models.