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Stock Valuation and Investment Strategies

55 Pages Posted: 26 Jul 2001  

Ming Dong

York University - Schulich School of Business

Zhiwu Chen

University of Hong Kong; Yale University - International Center for Finance; Zebra Capital Management, LLC

Date Written: June 30, 2001

Abstract

This article studies the relative investment performance of several stock-valuation measures. The first is mispricing based on the valuation model developed by Bakshe and Chen (1998)and extended by Dong (1998) (hereafter, the BCD model). The BCD model relates, in closed form, a stock's fair value to (i) the firm's net earnings per share (EPS). (ii) the expected future EPS growth and (iii) long-term rate. The second is a value/ price (V/P) ratio based on the Lee-Myers-Swaminathan (1999) residual-income model. The other measures are all indirect valuation indicators, including book/market (B/M), earnings/price (E/P), size, and past return momentum. These measures are shown to possess distinct properties. For example, the B/M, E/P and V/P ratios are highly persistent over time: high (low) B/M stocks tend to maintain high (low) B/M ratios. But, the BCD model mispricing is highly mean-reverting: an overpriced group will eventually become underpriced (in about 1.5 years on average), and vice versa. More importantly, the BCD model mispricing, momentum, size V/P and B/M are, in decreasing order, significant ex ante predictors of future returns. The best investment strategy is to combine the BCD model mispricing with momentum rankings. Indeed, if one would hold an equally-weighted portfolio of stocks that are the most underpriced and that have top momentum, the average monthly return from 1979 to 1996 would have been 3.18 percent, with a monthly Jensen's alpha of about 1.5 percent.

Keywords: Stock Valuation, Book/Market, Earnings/Price, Firm Size, Price Momentum, Stock Returns, Investment Management

JEL Classification: G10, G12, G131

Suggested Citation

Dong, Ming and Chen, Zhiwu, Stock Valuation and Investment Strategies (June 30, 2001). Yale ICF Working Paper No. 00-46. Available at SSRN: https://ssrn.com/abstract=277008 or http://dx.doi.org/10.2139/ssrn.277008

Ming Dong

York University - Schulich School of Business ( email )

4700 Keele Street
Toronto, Ontario M3J 1P3
Canada
416-736-2100 ext. 77945 (Phone)
416-736-5687 (Fax)

Zhiwu Chen (Contact Author)

University of Hong Kong ( email )

Pokfulam Road
Hong Kong
China

Yale University - International Center for Finance ( email )

Box 208200
New Haven, CT 06520-8200
United States
203-432-5948 (Phone)
203-432-6970 (Fax)

Zebra Capital Management, LLC ( email )

612 Wheelers Farms Road
Milford, CT 06461
United States

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