A Characteristic Model for Asset Pricing

Abstract:     
This paper develops a characteristic regression model that identifies firm characteristics that forecast stock returns. Forecasting returns is shown to be equivalent to forecasting earnings and earnings growth, so that a characteristic indicates expected returns if it indicates expected earnings and earnings growth that the market prices as risky. We identify two important modifications to the standard set of characteristics used to explain cross-sectional variation in equity returns. First, we show that earnings-to-price is missing from the standard set of characteristics. Second, we show that book-to-price (B/P) is a valid characteristic, as it is positively associated with future (risky) earnings growth. This is a surprising result as most prior research labels low B/P stocks as ‘growth’ stocks. As a validation of our model we revisit the puzzling negative relation that has been observed between leverage and realized returns. We find a positive relation between leverage and realized returns when returns are conditioned on the set of characteristics identified by our model.

Number of Pages in PDF File: 56

working papers series