The Price is (Almost) Right
Randolph B. Cohen
Harvard Business School - Finance Unit
London School of Economics
Arrowstreet Capital, LP; National Bureau of Economic Research (NBER)
NBER Working Paper No. w10131
Most previous research tests market efficiency and asset pricing models using average abnormal trading profits on dynamic trading strategies, and typically rejects the joint hypothesis. In contrast, we measure the ability of a simple risk model and the efficient-market hypothesis to explain the level of stock prices. First, we find that cash-flow betas (measured by regressing firms' earnings on the market's earnings) explain the prices of value and growth stocks well, with a plausible premium. Second, we use a present-value model to decompose the cross-sectional variance of firms' price-to-book ratios into two components due to risk-adjusted fundamental value and mispricing. When we allow the discount rates to vary with cash-flow betas, the variance share of mispricing is negligible.
Number of Pages in PDF File: 61working papers series
Date posted: December 8, 2003
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