Working Paper: NBER ID: w30967
Authors: Lin William Cong; Nathan Darden; George Guojun Wang
Abstract: We document that value-to-price, the ratio of Residual-Income-Model-based valuation to market price, subsumes the power of book-to-market ratio and many other value or quality measures in predicting stock returns. Long-short value-to-price portfolios hedge against momentum, revitalize the seemingly missing value premium over past decades, and generate significant returns after adjusting for common factors. The value-price-divergence (VPD) factor constructed from the average returns of these portfolios within small and big stocks is not spanned by these known factors. Max Sharpe ratio and constrained R-squared tests reveal that VPD is a better substitute for the traditional value factor and a four-factor model using the VPD, market, momentum, and size factors outperforms most extant benchmarks in explaining the cross-section of expected equity returns. The findings remain robust under alternative specifications of equity cost of capital.
Keywords: Value Investing; Valuation; Stock Returns; Asset Pricing
JEL Codes: C52; G11; G12; M41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| valuetoprice ratio (VP) (D46) | future stock returns (G17) |
| valuetoprice ratio (VP) (D46) | value-price divergence (VPD) performance (D46) |
| value-price divergence (VPD) (D46) | future stock returns (G17) |
| valuetoprice ratio (VP) (D46) | better stock performance (G17) |