Using Accounting Earnings and Aggregate Economic Indicators to Estimate Firm-level Systematic Risk
48 Pages Posted: 29 May 2019
Date Written: May 11, 2019
We revisit the literature on using accounting earnings to estimate firm-level systematic risk. We use macroeconomic indicators to measure undiversifiable aggregate risk; conventional listed-firm indexes reflect an unrepresentative subset of aggregate assets and are expected to substantially mismeasure risk (Roll, 1977). Earnings and macroeconomic indicators are realized annual outcomes that are well aligned for capturing the contemporaneous co-movements that underlie systematic risk, whereas stock returns incorporate changes in expected future outcomes. The macroeconomic indicators we use reflect changes in aggregate supply and demand, providing a parsimonious model incorporating the two fundamental determinants of aggregate outcomes. We find that firms' earnings-based sensitivities (betas) to aggregate supply and demand shocks are negatively correlated, and explain twice the cross-section of returns as conventional "index" betas. They are correlated with firm characteristics employed in empirical asset pricing models, and explain one third of the explanatory power of those characteristics, suggesting that at least part of firm characteristics' predictive ability is due to their correlation with systematic risk. These results provide a theory-based equivalent to the empirically-based Ball, Sadka and Sadka (2009) results that principal components of earnings are correlated with principal components of returns, and explain a significant portion of the returns cross-section.
Keywords: asset pricing, earnings beta, demand, supply, systematic risk
JEL Classification: G12, M41
Suggested Citation: Suggested Citation