RIM-based Value Premium and Factor Pricing Using Value-Price Divergence

Abstract

Value-to-Price, the ratio of Residual-Income-Model-based valuation to market price, subsumes the power of book-to-market and to a large extent of various quality measures in predicting stock returns. A natural hedge against momentum, long-short Value-to-Price strategies resuscitate the value premium and generate significant returns even after adjusting for common factors. The value-price-divergence (VPD) factor, constructed from the average returns of the long-short Value-to-Price portfolios within small and big stocks, is not spanned by known factor models. Max-Sharpe-ratio and constrained R-squared tests reveal that factor models replacing the traditional value factor with the VPD factor better explain the cross-section of expected equity returns.

Keywords: Asset Pricing, Factor Models, Mispricing, RIM, Value Premium.