Research Reports from the Department of Operations
Document Type
Report
Publication Date
3-5-1969
Abstract
There has recently been an increasing amount of interest in security valuation models stemming both from their widening use in portfolio selection methods and from the attempt to integrate investment theory and financial management. In the latter situation, some type of security valuation model is necessary to identify and measure the market response to internal financing and investment decisions. In the literature, many cross-sectional models have shown very poor explanatory capability because the random disturbances have been so large that they have overpowered and obscured whatever systematic forces the model has been attempting to measure. Some authors have endeavored to overcome this by using, directly or indirectly, a regression residual from initial or preliminary models as an independent variable in the final model. This residual has been given a variety of names, such as aberration factor, firm effect, etc., in the operational model. While we readily admit that the repeated appearance of a large and consistent residual for a particular company indicates the existence of some unidentified factor or factors, the use of this residual as an independent variable contributes little to the identification and measurement of these factors and certainly has no foundation in the mathematical-econometric logic which ought to be the basis of any security valuation model. In this paper, we will show that striking improvement in a security valuation model’s explanatory power can be obtained by first classifying companies into an equivalent risk category, estimating the discount factor for that category, and then constructing a separate cross-sectional model for it.
Keywords
Operations research, Securities--Valuation, Portfolio management, Investment analysis, Econometric models, Regression analysis, Risk--Mathematical models, Financial risk management
Publication Title
Technical Memorandums from the Department of Operations, School of Management, Case Western Reserve University
Issue
Technical memorandum no. 137
Rights
This work is in the public domain and may be freely downloaded for personal or academic use
Recommended Citation
Kuratani, Yoshiro; Bechtold, Joseph E.; and Mantel, Samuel J. Jr., "Defining the Role and Estimation of the Discount Factor in a Security Valuation Model" (1969). Research Reports from the Department of Operations. 130.
https://commons.case.edu/wsom-ops-reports/130