The Price is (Almost) Right
61 Pages Posted: 6 Mar 2005
Date Written: November 17, 2003
Most previous research tests market efficiency and asset pricing models using average abnormal trading profits on dynamic trading strategies, and typically rejects the joint hypothesis. In contrast, we measure the ability of a simple risk model and the efficient-market hypothesis to explain the level of stock prices. First, we find that cash-flow betas (measured by regressing firms' earnings on the market's earnings) explain the prices of value and growth stocks well, with a plausible premium. Second, we use a present-value model to decompose the cross-sectional variance of firms' price-to-book ratios into two components due to riskadjusted fundamental value and mispricing. When we allow the discount rates to vary with cash-flow betas, the variance share of mispricing is negligible.
Keywords: stock prices, present value, book-to-market, variance decomposition, capital asset pricing model, beta, expected returns, return on equity
JEL Classification: G120, G140
Suggested Citation: Suggested Citation