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

2025-05-30

AI Summary

This paper investigates whether the value-to-price (V/P) ratio predicts long-horizon stock excess returns and reflects systematic mispricing. Method: Using U.S. equity data from 1963–2023, we construct long–short portfolios sorted on V/P and evaluate predictive power via factor-sorted portfolio analysis, cross-sectional regressions, and Fama–French three- and five-factor model specifications. Contribution/Results: V/P exhibits robust, economically significant, and risk-factor–independent predictability for 1–3 year ahead returns; high-V/P portfolios generate significantly positive annualized alphas. Profitability and investment factors explain only a portion of V/P’s return premium—particularly in years 2–3, substantial unexplained excess returns persist. We provide the first systematic evidence that the V/P anomaly stems from persistent market misjudgment of the relationship between equity intrinsic value and the durability of earnings/investment growth, offering novel support for residual-income–based valuation bias.

Technology Category

• Data Mining & Knowledge Management: Anomaly/Outlier Detection
• Knowledge Representation and Reasoning: Preferences
• Reasoning under Uncertainty: Other Foundations of Reasoning under Uncertainty

Application Category

• Economics, Online Markets and Human Computation: Sustainability of Web economics
• Social Networks and Social Media: Influence propagation, information diffusion, and the prediction on networks
• Graph Algorithms and Modeling for the Web: Foundation models and LLMs for Web-related graphs

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.

Problem

• Examine if V/P ratio predicts excess stock returns
• Assess V/P's correlation with future returns controlling for risks
• Determine if profitability and investment explain V/P excess returns

Innovation

• Uses V/P ratio for portfolio sorting
• Controls firm characteristics as risk proxies
• Extends Fama-French model with profitability factors