Working Paper: NBER ID: w10131
Authors: Randolph B. Cohen; Christopher Polk; Tuomo Vuolteenaho
Abstract: Most previous research tests market efficiency and asset pricing models using average abnormal trading profits on dynamic trading strategies, and typically rejects the joint hypothesis. In contrast, we measure the ability of a simple risk model and the efficient-market hypothesis to explain the level of stock prices. First, we find that cash-flow betas (measured by regressing firms' earnings on the market's earnings) explain the prices of value and growth stocks well, with a plausible premium. Second, we use a present-value model to decompose the cross-sectional variance of firms' price-to-book ratios into two components due to risk-adjusted fundamental value and mispricing. When we allow the discount rates to vary with cash-flow betas, the variance share of mispricing is negligible.
Keywords: Market Efficiency; Asset Pricing; Cash Flow Betas; Stock Prices; Value and Growth Stocks
JEL Codes: G12; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| CAPM (O22) | stock prices (G12) |
| mispricing (D49) | stock prices (G12) |
| cash flow betas (G12) | stock prices (G12) |
| cash flow betas (G12) | mispricing (D49) |
| cash flow betas (G12) | price-to-book ratios (G32) |