Generalized Financial Ratios to Predict the Equity Premium

40 Pages Posted: 8 Sep 2016 Last revised: 17 May 2019

See all articles by Andres Algaba

Andres Algaba

Vrije Universiteit Brussel (VUB)

Kris Boudt

Ghent University; Vrije Universiteit Brussel; Vrije Universiteit Amsterdam

Date Written: May 11, 2017

Abstract

Empirical evidence for the price-dividend ratio to be a predictor of the equity premium is weak. We argue that changes in the economic conditions and market composition lead to a time-varying relationship between prices, dividends and the equity premium. Exploiting the information in the rolling window log-log regression of stock prices on dividends, we obtain the Generalized Price-Dividend Ratio (GPDR), that compares the price per share with a time-varying transformation of the dividend per share. The GPDR leads to economic and statistical gains when forecasting the equity premium of the S&P 500 at the 1, 3, 6 and 12 month horizon, as compared to using the classical price-dividend ratio or the prevailing historical average excess market return. Similar improvements are obtained for Generalized Financial Ratios based on the corporate earnings and book value.

Keywords: Equity premium, ERP, Forecast combination, Price-dividend ratio, Financial ratios, Time-varying parameters

JEL Classification: C10, G11

Suggested Citation

Algaba, Andres and Boudt, Kris, Generalized Financial Ratios to Predict the Equity Premium (May 11, 2017). Economic Modelling, 66, 244-257, 2017. Available at SSRN: https://ssrn.com/abstract=2835124 or http://dx.doi.org/10.2139/ssrn.2835124

Andres Algaba

Vrije Universiteit Brussel (VUB) ( email )

Pleinlaan 2
http://www.vub.be
Brussels, 1050
Belgium

Kris Boudt (Contact Author)

Ghent University ( email )

Sint-Pietersplein 5
Gent, 9000
Belgium

Vrije Universiteit Brussel ( email )

Pleinlaan 2
http://www.vub.ac.be/
Brussels, 1050
Belgium

Vrije Universiteit Amsterdam ( email )

De Boelelaan 1105
Amsterdam, ND North Holland 1081 HV
Netherlands

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