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Fundamental Extrapolation and Stock Returns

We explore the effects of fundamental extrapolation on stock returns. Empirically, we propose a novel approach to extrapolate firms' fundamental information and find that a strategy based on fundamental extrapolation earns an average return of 0.80% per month. Theoretically, we show that fundamental extrapolation has dual effects on stock price: a cash flow effect and a discount rate effect. The former pushes stock price up relative to its fundamental value, whereas the latter increases the representative investor's expected volatility and depresses today's stock price. Our empirical results suggest that the discount rate effect dominates the cash flow effect overall.