Accounting Data, Market Values, and the Cross Section of Expected Returns Worldwide

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.

Valuation: Accounting for Risk and the Expected Return. Discussion of Penman

“…In a follow‐up study, Chattopadhyay et al . () find that a similar model, but with fewer assumptions, forecasts out‐of‐sample stock returns in 26 out of 29 international markets, whereas factor‐based models forecast returns in one out of 29. That country is Pakistan.…”

“…An important implication, which Chattopadhyay et al . () point out, is that, if bp satisfies this condition, then growth in book and the growth in market must converge. They test these assumptions in many countries around the world and find compelling evidence in favour of them.…”

“…Chattopadhyay et al . () identify this shortcoming of the Vuolteenaho () approach and show that one can generate a similar equation to equation without the requirement of payment of dividends. The only condition is that the bp must have a finite and time‐invariant unconditional mean.…”

Valuation: Accounting for Risk and the Expected Return

“…The model is implemented in a vector autoregressive (VAR) scheme to estimate the linear dependencies in the time series evolution of indicator variables and returns and, in turn, to identify the three return components from residuals from the modelling. In Lyle and Wang () and Chattopadyhay et al (), the model is applied to estimate the expected return from accounting data as an alternative to ICC calculations, and with success in predicting returns out of sample. Unlike the analysis in this paper, the modelling has the appealing feature of explicitly connecting accounting numbers to the expected return and its variation.…”

“…And/or, ROE is assumed to evolve according to an autoregressive parameter to equal the expected (stock) return, ER τ in the long run. Chattopadyhay et al () allow for the expectation P τ – B τ to be non‐zero but constant in the long run. However, they maintain the autoregressive assumption such that growth in book value and market value converge linearly to zero over time and ROE is anchored on the long‐run expected return.…”