Explaining Returns through Valuation

57 Pages Posted: 23 Mar 2017 Last revised: 27 Oct 2019

See all articles by Erik Johannesson

Erik Johannesson

City University of NY, Baruch College, Zicklin School of Business

James A. Ohlson

Hong Kong Polytechnic University - School of Accounting and Finance

Date Written: October 23, 2019

Abstract

This paper develops an analytically coherent yet parsimonious framework which explains market returns in terms of contemporaneous information. It anchors on the idea that valuation (static perspective) can be connected to the dynamics that explains returns, and vice versa. The framework requires two components. First, an explicit function that maps information to an estimate of value—a valuation heuristic. Second, the framework assumes that the difference between a firm’s actual value and value-per-heuristic follows an autoregressive stochastic process with a contraction parameter but no intercept. The contraction parameter can be estimated efficiently and non-parametrically. This modelling suffices to correlate implied returns with realized returns. Using scaled EPS forecasts as valuation heuristics, we empirically evaluate the framework’s validity and robustness. Its explanatory power compares favorably to that of traditional OLS regressions, despite only requiring a single parameter. In a setting with pooled annual data, the implied and realized returns correlations are 73% and 64%, respectively.

Keywords: market returns, valuation, goodness-of-fit, valuation gap, ARF, autoregressive framework, parsimony

JEL Classification: M1, M41, G32, G12

Suggested Citation

Johannesson, Erik and Ohlson, James A., Explaining Returns through Valuation (October 23, 2019). Columbia Business School Research Paper No. 17-38. Available at SSRN: https://ssrn.com/abstract=2938103 or http://dx.doi.org/10.2139/ssrn.2938103

Erik Johannesson (Contact Author)

City University of NY, Baruch College, Zicklin School of Business ( email )

One Bernard Baruch Way
New York, NY 10010
United States

James A. Ohlson

Hong Kong Polytechnic University - School of Accounting and Finance ( email )

M715, Li Ka Shing Tower
Hung Hom, Kowloon
China

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