If stocks were severely undervalued in the late 1970s and early 1980s, then the bull market of the last 16 years may have been partly just a correction to more normal valuation levels. This paper tests the hypothesis that investors suffer inflation illusion and make two cognitive valuation errors, resulting in the undervaluation of equities in the presence of inflation. Investors fail to add to income the real depreciation of nominal liabilities that occurs because of inflation—resulting in the undervaluation of levered firms in the presence of inflation. In addition, they use nominal discount rates to value real cash flows—resulting in the entire stock market being undervalued when inflation is high. Using firm level data and a residual income/EVA model, we find evidence that errors in the valuation of levered firms during inflationary times result in depressed stock prices.
|Advisor:||Ritter, Jay R.|
|School:||University of Florida|
|School Location:||United States -- Florida|
|Source:||DAI-A 60/06, Dissertation Abstracts International|
|Keywords:||Bull market, Equity valuation, Inflation, Stock market|
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