Explaining Returns through Valuation

57 Pages Posted: 23 Mar 2017 Last revised: 3 Feb 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: February 1, 2019

Abstract

This paper develops an analytically coherent yet parsimonious framework to explain market returns in a novel way: valuation is connected to returns and vice versa. The framework requires two components. First, an explicit valuation model that maps information to an estimate of value. Second, the assumption that differences between firms’ actual values and values-per-model — valuation gaps — follow an autoregressive stochastic process with a single attenuation parameter and no intercept. Empirical analyses evaluate the framework’s robustness and validity. The attenuation parameter can be estimated simply and efficiently. Given an estimate of this sole parameter, the framework yields implied returns which can be correlated with realized returns. The framework’s explanatory power compares favorably to that of traditional OLS regressions, even though the former requires only one degree of freedom. In a setting with pooled annual data, the correlation between implied and realized returns 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 (February 1, 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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