Stock Values, Economic Earnings, and the Earnings Capitalization Rate

Explaining stock values in an earnings-based model requires determining the best measure of earnings. This paper develops alternative measures of aggregate earnings. We then argue that stock values are based on an economic definition of earnings. We show that the behavior of real stock values during the 1954-87 period is not fully explained by even this definition of earnings. Thus, we develop a measure of the rate at which these earnings are capitalized, and examine the role of this capitalization rate in determining stock value behavior. We show that a rise in the risky component of the capitalization rate during the 1970s played a major role in the decline in real stock values over this period. Finally, we show that a rise in the level of unanticipated inflation has a significant positive relationship with this risky component of the capitalization rate, and thus, at least in part, explains the rising rate and the falling real stock values.