Abstract
We propose a methodology to incorporate risk measures based on economic fundamentals directly into the valuation model. Fundamentals-based risk adjustment in the residual income valuation model is captured by the covariance of ROE with market-wide factors. 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. We show how the covariance risk estimate can be transformed to obtain the fundamentals-based cost of equity. Our empirical analysis shows that value estimates based on fundamental risk adjustment produce significantly smaller deviations from price relative to the CAPM or the Fama-French three-factor model. We further 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, largely accounting for the "mispricing" of value and growth stocks. Our study highlights the usefulness of accounting numbers in pricing risk beyond their role as trackers of returns-based measures of risk.
Original language | English (US) |
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Pages (from-to) | 1983-2011 |
Number of pages | 29 |
Journal | Accounting Review |
Volume | 84 |
Issue number | 6 |
DOIs | |
State | Published - Nov 2009 |
Keywords
- Accounting beta
- Cost of capital
- Covariance risk
- Value-growth anomaly