Can Cash-Flow Beta Explain the Value Premium?

37 Pages Posted: 30 Sep 2018

See all articles by Bo Zhou

Bo Zhou

Rutgers, The State University of New Jersey, Rutgers Business School

Date Written: September 5, 2018

Abstract

It is well documented that the cash flow beta can partly explain the source of the value premium. This paper presents an empirical test that cast doubt on this widely accepted belief. We double sort the stocks with their value and quality dimension and obtain four corner portfolios: (A) expensive quality, (B) cheap junk, (C) cheap quality and (D) expensive junk stocks. Prior research has shown that the value premium concentrates on cheap quality minus expensive junk (i.e. undervalued minus overvalued) but is not significant in cheap junk minus expensive quality stocks. If cash-flow beta is the source of the value premium, we would expect a larger cash-flow beta difference between the cheap quality and expensive junk portfolio. However, our empirical test shows that β_CF ((B) cheap junk) - β_CF ((A) expensive quality) >>β_CF ((C) cheap quality)-β_CF ((D) expensive junk). In other words, B minus A does not contribute to the profit of the value premium but contribute most to the difference of the cash flow beta between value and growth portfolios. Therefore, our result may serve as evidence that the cash flow beta may only spuriously explain the value premium. Or, at least, the cash-flow risk premium estimated in the portfolio regression approach is biased.

Keywords: Value premium, Gross profitability, Cash-flow beta, Analyst earnings beta, Portfolio regression

JEL Classification: G10, G12

Suggested Citation

Zhou, Bo, Can Cash-Flow Beta Explain the Value Premium? (September 5, 2018). Available at SSRN: https://ssrn.com/abstract=3244791 or http://dx.doi.org/10.2139/ssrn.3244791

Bo Zhou (Contact Author)

Rutgers, The State University of New Jersey, Rutgers Business School ( email )

Newark, NJ
United States

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