Back to fundamentals: The role of expected cash flows in equity valuation

To better understand how investors have historically valued equities, we compare monthly values of the S&P Index to our corresponding estimated fundamental values from 1871 to 2010, using ex ante available information. We find that the simple Gordon Growth Model performs better than other, more sophisticated valuation models. Based on the Gordon Growth Model, equities were undervalued prior to 1914, overvalued between 1914 and 1981, and fairly valued until 2010 after controlling for well-known economic and price-based factors. We also find the implied market risk premium over this period is around 5%. (C) 2011 Elsevier Inc. All rights reserved.