Expected Returns Dynamics Implied by Firm Fundamentals
Matthew R. Lyle
University of Toronto - Rotman School of Management
Charles C. Y. Wang
Harvard Business School
March 25, 2013
Harvard Business School Accounting & Management Unit Working Paper No. 13-050
Rotman School of Management Working Paper No. 2182628
We provide a tractable stock valuation model to study the dynamics of firm-level expected returns and their valuation impact using two firm fundamentals: book-to-market ratio and ROE. Applying the model to the cross-section of firms, we find that expected returns and expected profitability are highly persistent and time-varying. Our fundamentals-implied estimates of expected returns across time horizons exhibit strong return predictability up to three years ahead, and produce an aggregate equity term structure that tracks economic conditions. The implied term structure is upward sloping during normal or expansion periods, but flattens or inverts during economic downturns or times of high uncertainty. Finally, we show that ignoring the dynamics of expected returns can produce large valuation errors.
Number of Pages in PDF File: 50
Keywords: Term structure, expected returns, discount rates, fundamental valuation
JEL Classification: G12, G17, G10working papers series
Date posted: December 2, 2012 ; Last revised: March 26, 2013
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