Explaining Returns through Valuation
57 Pages Posted: 23 Mar 2017 Last revised: 3 Feb 2019
Date Written: February 1, 2019
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: Suggested Citation