Do Decomposed Financial Ratios Predict Stock Returns and Fundamentals Better?

45 Pages Posted: 22 Jan 2010 Last revised: 29 Jan 2010

See all articles by Xiaoquan Jiang

Xiaoquan Jiang

Florida International University (FIU) - Department of Finance

Bong-Soo Lee

Florida State University

Multiple version iconThere are 2 versions of this paper

Date Written: November 2009

Abstract

We investigate the prediction of excess returns and fundamentals by financial ratios – dividend-price ratio, earnings-price ratio, and book-to-market ratio – by decomposing financial ratios into a cyclical component and a stochastic trend component. We find both components predict excess returns and fundamentals. The cyclical components predict increases in future stock returns, while the stochastic trend components predict declines in future stock returns, in particular, in long horizons. This helps explain previous findings that financial ratios in the absence of decomposition find weak predictive power in short horizons and some predictive power in long horizons. We also find both components predict fundamentals, consistent with present value models.

Keywords: Financial ratios, Return predictability, Decomposition, Fundamentals

JEL Classification: G12, G14

Suggested Citation

Jiang, Xiaoquan and Lee, Bong-Soo, Do Decomposed Financial Ratios Predict Stock Returns and Fundamentals Better? (November 2009). Available at SSRN: https://ssrn.com/abstract=1535585 or http://dx.doi.org/10.2139/ssrn.1535585

Xiaoquan Jiang (Contact Author)

Florida International University (FIU) - Department of Finance ( email )

University Park
11200 SW 8th Street
Miami, FL 33199
United States

Bong-Soo Lee

Florida State University ( email )

423 Rovetta Business Building
Tallahassee, FL 32306-1110
United States
850-644-4713 (Phone)

HOME PAGE: http://www.cob.fsu.edu/fin/display_faculty_info.cfm?pID=401

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