An Accounting-Based Characteristic Model for Asset Pricing

64 Pages Posted: 30 Nov 2011 Last revised: 10 Nov 2015

See all articles by Stephen H. Penman

Stephen H. Penman

Columbia University - Columbia Business School, Accounting, Business Law & Taxation

Francesco Reggiani

Free University of Bozen-Bolzano

Scott A. Richardson

London Business School; Acadian Asset Management

A. Irem Tuna

London Business School

Date Written: November 9, 2015

Abstract

The paper presents an accounting framework for identifying characteristics that indicate expected returns. A model links expected returns to expected earnings and earnings growth, so a characteristic indicates expected returns if it indicates expected earnings and earnings growth that the market prices as being at risk. In applying the framework, the paper confirms book-to-price (B/P) as a valid characteristic in asset pricing: B/P is associated with higher expected earnings growth and also captures the risk of that growth not being realized. However, the framework also points to the forward earning-to-price (E/P) as a risk characteristic. Indeed, E/P, rather than B/P, is the relevant characteristic when there is no expected earnings growth, but the weight shifts to B/P with growth. The framework also enables the separation of the expected return for operating risk from that due to financing risk. With this separation, the paper revisits the puzzling negative relation that has been observed between leverage and realized returns, a finding that has been attributed to failure to control for operating risk. We find a positive relation between leverage and returns when operating risk characteristics identified by our model are recognized.

Suggested Citation

Penman, Stephen H. and Reggiani, Francesco and Richardson, Scott Anthony and Tuna, Ayse Irem, An Accounting-Based Characteristic Model for Asset Pricing (November 9, 2015). Available at SSRN: https://ssrn.com/abstract=1966566 or http://dx.doi.org/10.2139/ssrn.1966566

Stephen H. Penman (Contact Author)

Columbia University - Columbia Business School, Accounting, Business Law & Taxation ( email )

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Francesco Reggiani

Free University of Bozen-Bolzano ( email )

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Bozen-Bolzano, BZ 39100
Italy

Scott Anthony Richardson

London Business School ( email )

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Acadian Asset Management ( email )

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Boston, MA 02110
United States

Ayse Irem Tuna

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

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