A comparison of investors' sentiments and risk premium effects on valuing shares

- We investigate if sentiment and/or risk premium effects explain deviations of share prices from their fundamental values.
- Analyst forecasts for company earnings and book values of UK based firms over the years 1987-2012, are used.
- Panel data techniques considering also unobserved factors in the estimation of the model are employed.
- We find that together with risk premium, investors' sentiments explain most of these deviations.

This paper investigates at what extent deviations between market share prices and their fundamental values can be explained by risk premium and/or investors' sentiment effects. This is done based on recent panel data econometric techniques controlling for the effects of unobserved common factors on our estimation and inference procedures. To calculate the fundamental values of the shares, the paper relies on book value and yearly earnings forecasts of the listed companies, over the period 1987-2012. The results of the paper indicate that share price deviations from their fundamental values can be explained by both risk premium and sentiment effects. The latter lead to overvaluation of market share prices during normal market time times. In contrast, during periods of financial crises, share prices tend to reverse to their fundamental values. The unobserved common factors identified by fitting our model into the data do not add too much to the explanatory power of it, compared to the observed economic variables often used in the literature to capture the sentiment and/or risk premium effects.