Underdiversification puzzle, volatility puzzle and equity premium puzzle: a common solution

What is it about?

In the conventional valuation of long-term assets, only the DCF value appears on the left-hand side of the balance sheet; and in the conventional valuation of equity, only the DCF value appears on the right-hand side of the balance sheet; and in the end the balance sheet balances. This paper argues that since the real-options literature has shown that the more accurate value of the long-term assets requires the addition of “real options” to the DCF value of those long-term assets; in a similar fashion, the more accurate value of the equity requires the addition of “option value of stock’s upward potential” to the DCF value of equity; and in the end, again, the balance sheet balances. That is, whereas in the conventional case, the DCF value appears on each side of the balance sheet; this paper uses the insight of option-pricing theory and adds to each side of the balance sheet an option value, and therefore, the balance sheet equality is maintained.

Featured Image