A Profit System Model of Stock Market Valuation
As discussed in previous chapters, our profit system model provides estimates and forecasts of total profits for both individual firms and groups of firms. Here we consider its application to groups of firms with stock prices that are aggregated into a general stock market price index. First, we use our model to generate in-sample estimates and out-of-sample forecasts of the total profits of corporate firms in a stock market index. Second, since corporate firms’ profits are available to shareholders, discounting these aggregate profits by an appropriate rate of return gives the present value of total profits. This present value represents an estimate of the intrinsic or underlying value of the stock market index. It is important to note that our stock market valuation model depends on profit system model estimates and forecasts of total profits. This approach is consistent with the long-standing and popular discounted cash flow(DCF) approach to stock market valuation.