A Dividend-Based Model to Explain the Cross Section of Equity Returns for Both Financial and Non-Financial Stocks

27 Pages Posted: 13 Oct 2017  

James Foye

University of Ljubljana

Aljosa Valentincic

University of Ljubljana - Faculty of Economics

Date Written: October 11, 2017

Abstract

Estimates of expected returns based upon the Fama-French and Carhart models typically exclude financial firms, including the latest FF five-factor model (Fama and French, 2015) or Gregory et al. (2013) for the UK. The presumed reason for this is that the book-price-based HML factor is not comparable between nonfinancial (predominantly historic-cost accounting) and financial firms (predominantly fair-value accounting). However, this approach excludes about 20% of FTSE 100 market capitalization. This paper proposes an alternative model of expected returns that can be applied to both sets of firms. To do this, we replace the HML factor with a dividend-yield-based factor which resolves the accounting issue present in the HML factor – thereby obviating the need to remove financial firms. We construct the factor based on dividend yield sorts in the same way as Fama-French calculate the HML factor based on book-price sorts. Empirically, we base our analyses on the UK market because a large proportion of firms there pay out dividends. We find that: i) replacing HML with PMR (payers-minus-retainers) produces equivalent results for nonfinancial firms; ii) the PMR factor is able to explain returns for portfolios of financial services stocks; iii) the model can be used to combine financial and nonfinancial firms in the same sample in analyses that require the calculation of expected returns.

Suggested Citation

Foye, James and Valentincic, Aljosa, A Dividend-Based Model to Explain the Cross Section of Equity Returns for Both Financial and Non-Financial Stocks (October 11, 2017). Available at SSRN: https://ssrn.com/abstract=3051173 or http://dx.doi.org/10.2139/ssrn.3051173

James Foye (Contact Author)

University of Ljubljana ( email )

Dunajska 104
Ljubljana, 1000
Slovenia

Aljosa Valentincic

University of Ljubljana - Faculty of Economics ( email )

Kardeljeva ploscad 17
Ljubljana, 1000
Slovenia

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