Residual-Income-Based Valuation Predicts Future Stock Returns: Evidence on Mispricing Versus Risk Explanations

34 Pages Posted: 5 May 2003

See all articles by Ashiq Ali

Ashiq Ali

University of Texas at Dallas - Naveen Jindal School of Management

Lee-Seok Hwang

Seoul National University - College of Business Administration

Mark A. Trombley

University of Arizona - Eller College of Management

Date Written: November 2002

Abstract

Frankel and Lee (1998) show that the value-to-price ratio (Vf/P) predicts future abnormal returns for up to three years, where Vf is an estimate of fundamental value based on a residual income valuation framework operationalized using analyst earnings forecasts. In this study, we examine whether the Vf/P effect is due to market mispricing or omitted risk factors. We find that the Vf/P effect is partially concentrated around the future earnings announcements, consistent with the mispricing explanation. On using an extensive set of risk proxies, suggested by Gebhardt et al. (2001) and Gode and Mohanram (2001), we also find that Vf/P is significantly related to some risk proxies. However, after controlling for these risk factors, Vf/P continues to exhibit a significant positive association with future returns suggesting that these risk factors are not responsible for the Vf/P effect. Overall, the results seem consistent with the mispricing explanation for the Vf/P effect.

Note: Previously titled "Residual-Income-Based Valuation and Future Stock Returns: Tests of the Market Mispricing Hypothesis"

Keywords: Residual income valuation, mispricing, risk

JEL Classification: D4, G12, G14, M4

Suggested Citation

Ali, Ashiq and Hwang, Lee-Seok and Trombley, Mark A., Residual-Income-Based Valuation Predicts Future Stock Returns: Evidence on Mispricing Versus Risk Explanations (November 2002). Available at SSRN: https://ssrn.com/abstract=285300 or http://dx.doi.org/10.2139/ssrn.285300

Ashiq Ali (Contact Author)

University of Texas at Dallas - Naveen Jindal School of Management ( email )

800 West Campbell Road, SM41
Richardson, TX 75080-3021
United States
972-883-6360 (Phone)
972-883-6811 (Fax)

HOME PAGE: http://www.utdallas.edu/~axa042200/

Lee-Seok Hwang

Seoul National University - College of Business Administration ( email )

Seoul, 151-742
Korea, Republic of (South Korea)

Mark A. Trombley

University of Arizona - Eller College of Management ( email )

McClelland Hall
P.O. Box 210108
Tucson, AZ 85721-0108
United States
520-621-4805 (Phone)
520-621-3742 (Fax)

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