A Theory of Firm Characteristics and Stock Returns: The Role of Investment-Specific Shocks

67 Pages Posted: 18 Mar 2012

See all articles by Dimitris Papanikolaou

Dimitris Papanikolaou

Northwestern University - Kellogg School of Management - Department of Finance; National Bureau of Economic Research (NBER)

Leonid Kogan

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER)

Date Written: March 6, 2012

Abstract

We provide a theoretical model linking firm characteristics and expected returns. The key ingredient of our model is technological shocks embodied in new capital (IST shocks), which affect the profitability of new investments. Firms's exposure to IST shocks is endogenously determined by the fraction of firm value due to growth opportunities. In our structural model, several firm characteristics -- Tobin's Q, past investment, earnings-price ratios, market betas, and idiosyncratic volatility of stock returns -- help predict the share of growth opportunities in the firm's market value, and are therefore correlated with the firm's exposure to IST shocks and risk premia. Our calibrated model replicates: i) the predictability of returns by firm characteristics; ii) the comovement of firms with similar characteristics; iii) the failure of the CAPM to price portfolio returns of firms sorted on characteristics; iv) the time-series predictability of market portfolio returns by aggregate investment and valuation ratios; and v) a downward sloping term structure of risk premia for dividend strips. Our model delivers testable predictions about the behavior of firm-level real variables -- investment and output growth -- that are supported by the data.

Suggested Citation

Papanikolaou, Dimitris and Kogan, Leonid, A Theory of Firm Characteristics and Stock Returns: The Role of Investment-Specific Shocks (March 6, 2012). AFA 2013 San Diego Meetings Paper. Available at SSRN: https://ssrn.com/abstract=2024036 or http://dx.doi.org/10.2139/ssrn.2024036

Dimitris Papanikolaou (Contact Author)

Northwestern University - Kellogg School of Management - Department of Finance ( email )

Evanston, IL 60208
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Leonid Kogan

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
E62-636
Cambridge, MA 02142
United States
617-253-2289 (Phone)
617-258-6855 (Fax)

HOME PAGE: http://web.mit.edu/lkogan2/www/

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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