Evaluation of the forecasting capability of selected valuation models for a long-term equity investment

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In the 1990s, the global stock market saw the emergence of a new technology sector and a remarkable rise in values, which abruptly ended in 2000 with a significant market drop. The technology sector was particularly hard hit, leading to a substantial loss of wealth. This raises the question of whether it was possible to predict stock prices in such a volatile environment, allowing investors to identify undervalued stocks. A crucial consideration for investors is whether an investment is fairly priced at the time of purchase, especially if they believe that stock prices can fluctuate between overvaluation and undervaluation before eventually aligning with their true values. To assess fair pricing, investors require a valuation model that offers a theoretically correct value as a benchmark for decision-making. In her study, Sussane Hakuba investigates the forecasting capabilities of two valuation models for long-term equity investments over a nine-quarter period (from Q4 1999 to Q4 2000): the two-stage free cash flow to equity (FCFE) model and the dividend discount model (DDM) as utilized by JPMorgan Fleming. Hakuba analyzes the application of these models, discussing their theoretical foundations, inputs, and assumptions, and provides insights into the stock valuations conducted, concluding with recommendations for future applications of the examined models.