Abstract
Under fairly general assumptions, expected stock returns are a linear combination of two accounting fundamentals ― book to market and ROE. Empirical estimates based on this relation predict the cross section of out-of-sample returns in 26 of 29 international equity markets, with a highly significant average slope coefficient of 1.05. In sharp contrast, standard factor-model-based proxies fail to exhibit predictive power internationally. We show analytically and empirically that the importance of ROE in forecasting returns depends on the quality of accounting information. Overall, a tractable accounting-based valuation model provides a unifying framework for obtaining reliable proxies of expected returns worldwide.
Highlights
Estimating expected returns has been a centerpiece in financial economics since at least the derivation of the CAPM (Sharpe, 1964)
Armed with the bm ratio in Eq, (8) and assuming, as in Pastor and Veronesi (2003), that accounting satisfies clean surplus and that dividends are proportional to book value over the interval, we show in the Appendix that expected returns is a linear combination of the book-to-market ratio and expected ROE: Et[rt+1] = A1 + A2bmt + A3Et[roet+1], (10)
We show in the Appendix that when the accounting system is imperfect, expected stock returns are a linear combination of bm and roe: E[rt+1|Ft] = C1(t) + C2(t)ft−1 + C3bmt + C4(t)roet, (22)
Summary
Estimating expected returns has been a centerpiece in financial economics since at least the derivation of the CAPM (Sharpe, 1964). Our simple accounting-based ERPs perform well across the world: they significantly and reliably predict the cross section of stock returns in 26 of 29 equity markets worldwide They line up well with true expected returns. By relating the accounting-based model of expected returns to a dynamic information structure, we show analytically that, holding all other sources of information constant, higher-quality accounting information—defined by lower measurement error variance—increases the importance of ROE in determining expected returns These predictions are supported by our empirical tests. Provides a framework for understanding why various characteristics (accounting data and valuation ratios) relate to future stock returns: they carry information about future ROE This analytical result suggests that the empirical approach used by Ou and Penman (1989), coupled with our parsimonious model, may offer an exciting area of potential future research in accounting and characteristic-based asset pricing.
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