Modeling growth stocks via birth-death processes

Abstract

The inability to predict the future growth rates and earnings of growth stocks (such as biotechnology and internet stocks) leads to the high volatility of share prices and difficulty in applying the traditional valuation methods. This paper attempts to demonstrate that the high volatility of share prices can nevertheless be used in building a model that leads to a particular cross-sectional size distribution. The model focuses on both transient and steady-state behavior of the market capitalization of the stock, which in turn is modeled as a birth-death process. Numerical illustrations of the cross-sectional size distribution are also presented.