The Finite Horizon Expected Return Model

Abstract

The finite horizon expected return model (FHERM), a new method for estimating the expected return on a share, states that (1) forecasts of abnormal performance have a finite horizon, N, beyond which investors expect a corporation to earn for all future time a return on equity investment equal to the expected return on its shares; and (2) the expected return on a share is the discount rate that equates the share's current price with a dividend expectation for which the dividend in each period from 1 to N is equal to its forecast and the dividend in each period from N + 1 to infinity is equal to the forecast for normalized earnings in Period N + 1. The capital asset pricing model (CAPM) states that the expected return on a share varies with beta and dividend yield, but empirical tests of the CAPM using previous methods for estimating expected return have failed. Empirical evidence strongly supports the joint hypothesis that the FHERM and the CAPM are both true.