A Fundamental Factor Model

78 Pages Posted: 3 Nov 2018 Last revised: 6 Dec 2018

See all articles by Stephen H. Penman

Stephen H. Penman

Columbia Business School - Department of Accounting

Julie Zhu

Fanhai International School of Finance(FISF), Fudan University

Date Written: October 1, 2018


This paper constructs a fundamental pricing factor based on observed accounting information. In contrast to standard models where accounting data often enter via data dredging, the factor is founded on consumption-based asset pricing theory and accounting principles that connect accounting numbers to consumption at risk. The factor performs well relative to standard factors in explaining cross-sectional returns. Further, it delivers out-of-sample expected returns that forecast the actual returns that investors receive, a feature on which extant asset pricing models perform poorly. The factor return has little correlation with the market portfolio, and exhibits the property of protecting payoffs in bad states when consumption is low. This prompts a two-factor representation that combines the market portfolio and a zero-beta portfolio with a hedge against loss to consumption.

Suggested Citation

Penman, Stephen H. and Zhu, Julie, A Fundamental Factor Model (October 1, 2018). Columbia Business School Research Paper No. 18-76, Available at SSRN: https://ssrn.com/abstract=3264802 or http://dx.doi.org/10.2139/ssrn.3264802

Stephen H. Penman (Contact Author)

Columbia Business School - Department of Accounting ( email )

3022 Broadway
New York, NY 10027
United States
212-854-9151 (Phone)
212-316-9219 (Fax)

Julie Zhu

Fanhai International School of Finance(FISF), Fudan University ( email )

220 Handan Road
Shanghai, 200433

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