Dynamic Risk, Accounting-Based Valuation and Firm Fundamentals
Matthew R. Lyle
Kellogg School of Management
Jeffrey L. Callen
University of Toronto - Rotman School of Management
Robert J. Elliott
University of Calgary - Haskayne School of Business; University of Alberta - Department of Mathematical and Statistical Sciences
This study extends the accounting-based valuation framework of Ohlson (1995) and Feltham and Ohlson (1999) to incorporate dynamic expectations about the level of systematic risk in the economy. Our model explains recent empirical findings documenting a strong negative association between changes in economy-wide risk and future stock returns. Importantly, the model also generates costs of capital that are solely a linear function of accounting variables and other firm fundamentals including the book-to-market ratio, the earnings-to-price ratio, the forward earnings-to-price ratio, size and the dividend yield. This result provides a theoretical rationale for the inclusion of these popular variables in cost of capital (expected return) computations by the accounting and finance literatures and obviates the need to estimate costs of capital from unobservable (future) covariances. The model also generates an accounting return decomposition in the spirit of Vuolteenaho (2002). Empirically, we find that costs of capital generated by our model are significantly associated with future returns both in and out of sample in contrast to standard benchmark models. We further obtain significantly lower valuation errors in out-of-sample tests than traditional models that ignore dynamic risk expectations.
Number of Pages in PDF File: 38
Keywords: Stock valuation, expected risk, cost of capital, expected returns, implied risk, Ohlson model
JEL Classification: G12, M41
Date posted: March 27, 2012
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