The Convergence of Stock Price to Fundamental Value

Abstract

Frankel and Lee (1998) show that fundamental value-to-price ratios (V/P) predict future stock returns for up to three years. This empirical regularity (called the V/P effect) is consistent with the notion that extreme V/P ratio identify stocks that are initially mispriced but whose prices converge to fundamental value estimates over time. The existing evidence on price convergence is, however, indirect and incomplete. This paper examines whether price convergence explains the V/P effect and how price discovery occurs. We show that only 23% of the top and bottom V/P quintile stocks exhibit price convergence over the ensuing 36 months. This subsample is responsible for most of the trading strategy returns. Further, we show that price convergent subsample returns are disproportionately concentrated around future quarterly earnings announcements. The collective evidence supports mispricing, rather than risk, as an explanation for the V/P effect. Additional analyses show that price momentum explains the puzzling first-year delay in V/P trading strategy returns.

Keywords: Fundamental value, Fundamental analysis, Residual income valuation model, Mispricing

JEL Classification: G11, G12, G14, M41