Residual Income Valuation and Stock Returns: Evidence from a Value-to-Price Investment Strategy

TL;DR

This paper demonstrates that portfolios sorted by the V/P ratio yield excess returns in the US market, indicating persistent undervaluation and mispricing that are not fully explained by traditional risk factors.

Contribution

It provides empirical evidence that the V/P ratio is a valuable predictor of stock returns and enhances existing asset pricing models with additional explanatory power.

Findings

High V/P portfolios outperform low V/P portfolios over 1-3 years.

V/P ratio is positively correlated with future stock returns.

Traditional risk factors do not fully explain excess returns for high V/P stocks.

Abstract

We hypothesize that portfolio sorts based on the V/P ratio generate excess returns and consist of companies that are undervalued for prolonged periods. Results, for the US market show that high V/P portfolios outperform low V/P portfolios across horizons extending from one to three years. The V/P ratio is positively correlated to future stock returns after controlling for firm characteristics, which are well known risk proxies. Findings also indicate that profitability and investment add explanatory power to the Fama and French three factor model and for stocks with V/P ratio close to 1. However, these factors cannot explain all variation in excess returns especially for years two and three and for stocks with high V/P ratio. Finally, portfolios with the highest V/P stocks select companies that are significantly mispriced relative to their equity (investment) and profitability growth persistence in the future.