The X-value factor and the solution of the value premium puzzle
44 Pages Posted: 8 Apr 2019 Last revised: 1 Jul 2020
Date Written: July 1, 2020
X-value normalizes stock prices by the recursive out-of-sample expectation of each firm's net income, estimated by industry from its financials, while ignoring book equity. The resulting X-value factor is unspanned by the five Fama/French factors individually or in different combinations, and spans the value and investment premiums with a Sharpe ratio of 0.57 (compared to 0.39 for value). This evidence supports the value premium theory in which book equity is exclusively a proxy for expected cash flows - unrelated to risk - and contradicts theories that supposedly determine the "missing factor" for which book-to-market is a proxy.
Keywords: Risk premiums, stock returns, Fama and French, cash flow forecasting, out of sample
JEL Classification: G11, G12, G14
Suggested Citation: Suggested Citation