Business Value
Illusion of Money
The Modigliani-Cohn Hypothesis is a significant model that describes the nonrational behavior of asset pricing and its impact on the Equity Risk Premium.
According to the model, investors tend to differentiate between nominal and real numbers when assessing the value of assets (and non-obligations), and collectively, the market makes mistakes.
Here’s how it works:
When investors make forecasts for financial assets, they believe that an organization’s long-term growth rate should not change significantly. Because this assumption is often rationalized within the context of real (inflation-adjusted) numbers, investors make the assumption that the growth parameter in nominal numbers does not change – they believe that inflation will remain stable in the future.
Afterward, if inflation rises unexpectedly, investors do not adjust their forecasts for financial assets and only adjust for the increase in discounting (as nominal interest rate returns are higher), which leads the market to overestimate the valuation of assets, both individually and collectively.
Consequently, the market overvalues assets during periods of high inflation and undervalues them during periods of low inflation…
P.S. One crucial factor contributing to the significant fluctuations of growth in financial assets (as observed in my analysis) is that historical numbers are used in analytical evaluations… However, no company can sustain continuous and significantly high growth over long periods, and the volatility of growth over time poses a significant challenge to an organization’s valuation… Thus, as soon as a company reaches a stage of growth plateau and it becomes apparent that it will no longer grow at high rates over long periods, the stock price will decline…
MONEY ILLUSION IN THE STOCK MARKET: THE MODIGLIANI-COHN HYPOTHESIS*
RANDOLPH B. COHEN CHRISTOPHER POLK TUOMO VUOLTEENAHO