Accounting valuation, market expectation, and cross-sectional stock returns

TLDR

The study investigates whether an analyst‑based valuation model can predict cross‑sectional stock returns. Fundamental values were estimated from I/B/E/S consensus forecasts using a residual income model. The V/P ratio, derived from these valuations, strongly predicts long‑term cross‑sectional returns independent of beta, B/P, or market cap, and its predictive power improves when analyst forecast errors are incorporated.

Abstract

This study examines the usefulness of an analyst-based valuation model in predicting cross-sectional stock returns. We estimate firms' fundamental values (V) using I/B/E/S consensus forecasts and a residual income model. We find that V is highly correlated with contemporaneous stock price, and that the V/P ratio is a good predictor of long-term cross-sectional returns. This effect is not explained by a firm's market beta, B/P ratio, or total market capitalization. In addition, we find errors in consensus analyst earnings forecasts are predictable, and that the predictive power of V/P can be improved by incorporating these errors.