An Accounting-Based Characteristic Model for Asset Pricing
Stephen H. Penman
Columbia University - Department of Accounting
Bocconi University - Department of Accounting
Scott A. Richardson
London Business School; AQR Capital Management, LLC
A. Irem Tuna
London Business School
The paper presents an accounting framework for identifying characteristics that indicate expected returns. The framework 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. The framework validates 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. E/P is the only relevant characteristic when there is no expected earnings growth, but the weight shifts to B/P with growth. As a validation of our model, we revisit the puzzling negative relation that has been observed between leverage and realized returns. This has been attributed to failure to control for operating risk while examining the effect of leverage. We find a positive relation between leverage and returns when risk characteristics identified by our model are controlled for.
Number of Pages in PDF File: 53
Date posted: November 30, 2011 ; Last revised: September 23, 2013
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