A Multiples-Based Decomposition of the Value Premium

A new related paper has been added to:

#26 – Value (Book-to-Market) Anomaly

Authors: Golubov, Konstantinidi

Title: A Closer Look at the Value Premium: Evidence from a Multiples-Based Decomposition

Link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2702822


We use industry multiples-based market-to-book decomposition of Rhodes-Kropf, Robinson and Viswanathan (2005) to study the value premium. The market-to-value component drives all of the value strategy return, while the value-to-book component exhibits no return predictability in both portfolio sorts and firm-level return regressions controlling for other stock characteristics. Prior results in the literature linking value/glamor to expectational errors and limits to arbitrage hold due to the market-to-value component, whereas the results linking market-to-book to cashflow risk, exposure to investment-specific technology shocks, and analyst’s risk ratings hold only for the unpriced value-to-book. Overall, our evidence points towards the mispricing explanation for the value premium.

Notable quotations from the academic research paper:

"In this paper, we shed further light on the origins of the “value premium” using a market-to-book decomposition proposed by Rhodes–Kropf, Robinson, and Viswanathan (2005) (RRV hereafter) in their study of misvaluation and merger waves. In particular, the market-to-book ratio is decomposed into market-to-value and value-to-book components, where value is an estimate of fundamental value based on industry multiples conditional on a set of observable characteristics. The market-to-value component represents deviation of the stock price from fundamental value implied by long-run industry valuations, and the value-to-book component represents the “expected” industry-specific valuation of the firm’s net assets. The market-to-value component can be further decomposed into firm-specific deviation of the stock price from contemporaneous industry-level valuation, and the deviation of industry-level valuation from its long-run average.

We find that all of the return predictability of the market-to-book ratio is concentrated in the market-to-value component. Over the 1975-2013 period, a long-short portfolio strategy based on the conventionally used market-to-book ratio produces an average return of 1.42% per month (17.04% annualized). The same strategy based on the market-to-value component produces an average return of 1.56% (18.72% annualized), while going long low value-to-book and short high value-to-book stocks produces an average return of 0.27% per month – statistically insignificant. The Sharpe ratios of the market-to-value strategies are also superior to that of the conventional value strategy. Further decomposition of the market-to-value component into firm-level deviations from contemporaneous industry-level valuations and industry-level deviations from long-run averages shows that it is the firm-specific component that drives return predictability.

If high (low) market-to-value stocks are over (under)priced, we should find that investors are negatively (positively) surprised by their earnings announcements following portfolio formation. This is exactly what we find. We also find that high (low) market-to-value stocks experience positive (negative) earnings surprises in the quarters prior to portfolio formation, suggesting that the mechanism by which these stocks become mispriced is investor overextrapolation of positive (negative) news, leading to over (under)valuation that gets corrected over subsequent quarters as the true fundamentals are revealed. These patterns are not there for the value-to-book component.

We then examine the role of limits to arbitrage, such as short sale constraints and noise trader risk, in the sustaining of mispricing (De Long et al. (1990), Shleifer and Vishny (1997), Pontiff (2006)). In the absence of limits to arbitrage, overvaluation should not persist for long periods of time as the rational arbitrageurs trade against the mispricing. We find that the performance of the market-to-value strategy is concentrated in portfolios characterized by short sale constraints, as captured by institutional ownership and the existence of exchange-traded options. Moreover, these differences are largely due to high market-to-value stocks – the ones going into the short leg of the strategy – where short sale constraints are really binding. We also find that the market-to-value strategy returns are largely due to stocks characterized by noise trader risk as captured by idiosyncratic return volatility. Again, these effects are not there for value-to-book: the mispricing-based explanations of the market-to-book effect hold only for the component designed to capture mispricing."

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