Residual‐Income‐Based Valuation Predicts Future Stock Returns: Evidence on Mispricing vs. Risk Explanations

Abstract

Frankel and Lee (1998) show that the value‐to‐price ratio(Vf/P)predicts future abnormal returns for up to three years, whereVfis an estimate of fundamental value based on a residual income valuation framework operationalized using analyst earnings forecasts. In this study, we examine whether theVf/Peffect is due to market mispricing or omitted risk factors. We find that theVf/Peffect is partially concentrated around the future earnings announcements, consistent with the mispricing explanation. On using an extensive set of risk proxies, suggested by Gebhardt et al. (2001) and Gode and Mohanram (2001), we also find thatVf/Pis significantly related to some risk proxies. However, after controlling for these risk factors,Vf/Pcontinues to exhibit a significant positive association with future returns suggesting that these risk factors are not responsible for theVf/Peffect. Overall, the results seem consistent with the mispricing explanation for theVf/Peffect.