Fundamentals-Based Risk Measurement in Valuation
45 Pages Posted: 15 Sep 2006 Last revised: 26 Mar 2019
Date Written: January 1, 2007
We propose a methodology to incorporate risk measures based on economic fundamentals directly in the valuation model. Fundamentals-based risk adjustment in the residual income valuation model is captured by the covariance of excess ROE with market-wide factors. We simplify the covariance risk adjustment such that it can be easily implemented in a practical valuation setting. We demonstrate a method of estimating covariance risk out of sample based on the accounting beta and betas of size and book-to-market factors in earnings. Our empirical analysis shows that value estimates based on fundamental risk adjustment produce significantly smaller deviations from price compared to value estimates based on standard risk adjustment procedures using the CAPM or the Fama-French three-factor model. Further, we find that our single-factor risk measure, based on the accounting beta alone, captures aspects of risk that are indicated by the book-to-market factor and largely explains the "mispricing" of value and growth stocks. The paper highlights the usefulness of accounting numbers in pricing risk beyond their role as trackers of returns-based measures of risk. Accounting risk measures are based on firm fundamentals that indicate the source of risk and hence the use of these measures directly in valuation is appealing.
Keywords: Residual income valuation, covariance risk, accounting beta, book-to-market ratio
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