Why does the power law for stock price hold

Abstract The aim of this paper is to explain why the power law for stock price holds. We first show that the complementary cumulative distributions of stock prices follow a power law using a large database assembled from the balance sheets and stock prices of a number of worldwide companies for the period 2004 through 2013. Secondly, we estimate company fundamentals from a simple cross-sectional regression model using three financial indicators-dividends per share, cash flow per share, and book value per share—as explanatory variables for stock price. Thirdly, we demonstrate that the complementary cumulative distributions of fundamentals follow a power law. We find that the power laws for stock prices and for fundamentals hold for the 10-year period of our study, and that the estimated values of the power law exponents are close to unity. Furthermore, we illustrate that the tail distribution of fundamentals closely matches the tail distribution of stock prices. On these grounds, we conclude that the power law for stock price is caused by the power law behavior of the fundamentals.

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