Stock Prices and their fundamental value. Evidence from the Helsinki Stock Exchange

Abstract

This study investigates whether stock prices are determined by economic fundamentals or stated differently, whether the present value model can provide adequate explanation to the observed volatility in the stock market. This stems from the fact that there have been several studies in recent times in this subject area without a firm conclusion as to the role of the efficient market hypothesis (EMH) in stock price volatility and more specifically the question of whether stock prices are determined by fundamentals. The study uses both the variance bounds tests and regression tests to establish a clear-cut position, with the two methodologies producing similar results. These models, that is, the variance bounds and the regression analysis rejected the assertion that the discounted present value relations using only risk free rate determine stock prices. This was evident from the wide variations between the stock prices and fundamental value in both applications. In contrast, using both the risk free rate and the risk premium in the discounting process for the two models produce fundamental prices that are closer to actual prices. In general, this study provides another piece of evidence in support of the theory that the present value model augmented for risk premium and risk free rate that are time varying can provide adequate explanation to the observed stock price volatility. This goes to reemphasize the point that the fundamental components of stock prices play an active role in determining the ultimate price of any equity stock.