Abstract
This paper supplements the traditional security return model, by adding earnings yield to the risk-free rate, market risk, size, and book-to-market equity as predictors of security returns. Earnings yield is the ratio of net income to market price, so that it represents the segment of market price that depends upon operating performance of the firm, rather than market perception. This paper establishes a theoretical framework for the earnings yield construct, describing it as a predictor of return on assets, return on equity, economic value added, and the equity multiplier. Earnings yield, therefore, predicts the ability to purchase productive assets, achieve a positive return for shareholders, and increase debt capacity. Then, earnings yield is subjected to empirical testing through a regression of its impact on security returns, with the finding that it explained a significant amount of the variance in security returns beyond size and book-to-market equity.
Highlights
Traditional security return models ([1] [2] [3]) define the return on a security as the addition of premium for the security’s sensitivity to market fluctuations to the riskless rate. [4] added a size factor in response to findings of higher returns by small firms over large firms to account for the higher default risk and financial distress of small firms [5]
Given that the Internet has made the dissemination of information universal, information may be a free good in frictionless markets
This paper has added earnings yield as a measure of product attributes and the quality of managerial decision-making to explain security returns beyond risk measures and investment aberrations such as size variations, and book-to-market variations. This approach views security returns as more than a manifestation of market behavior as observed by distant outsiders, such as financial advisors and investment analysts. It views returns in terms of financial fundamentals, i.e. as the direct consequence of the ability of the firm to generate income that grows more rapidly than price through investments in assets, projects that earn more than the cost of capital and by increasing debt capacity
Summary
Traditional security return models ([1] [2] [3]) define the return on a security as the addition of premium for the security’s sensitivity to market fluctuations to the riskless rate. [4] added a size factor in response to findings of higher returns by small firms over large firms to account for the higher default risk and financial distress of small firms [5]. Managers who operate a firm have more information than outsiders, so that a measure derived from financial statements that reflect the ability of management to make sound financial decisions may increase security returns beyond that indicated by market measures Such managerial decisions may take the form of capitalizing upon growth opportunities, finding cheap sources of capital, investing in research and development, and making acquisitions in product innovators. Given that the Internet has made the dissemination of information universal, information may be a free good in frictionless markets It follows that it is more important to value a firm based on its ability to generate a stream of future cash flows by making judicious investments, rather than interpreting market signals.
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