Stock Valuation and Investment Strategies

Zhiwu Chen and Ming Dong
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Zhiwu Chen: Yale University - International Center for Finance
Ming Dong: York University - Schulich School of Business

Finance from EconWPA

Abstract: This article studies the relative investment performance of several stock-valuation measures. The first is mispricing based on the valuation model developed by Bakshe and Chen (1998)and extended by Dong (1998) (hereafter, the BCD model). The BCD model relates, in closed form, a stock's fair value to (i) the firm's net earnings per share (EPS). (ii) the expected future EPS growth and (iii) long-term rate. The second is a value/ price (V/P) ratio based on the Lee-Myers-Swaminathan (1999) residual-income model. The other measures are all indirect valuation indicators, including book/market (B/M), earnings/price (E/P), size, and past return momentum. These measures are shown to possess distinct properties. For example, the B/M, E/P and V/P ratios are highly persistent over time: high (low) B/M stocks tend to maintain high (low) B/M ratios. But, the BCD model mispricing is highly mean-reverting: an overpriced group will eventually become underpriced (in about 1.5 years on average), and vice versa. More importantly, the BCD model mispricing, momentum, size V/P and B/M are, in decreasing order, significant ex ante predictors of future returns. The best investment strategy is to combine the BCD model mispricing with momentum rankings. Indeed, if one would hold an equally-weighted portfolio of stocks that are the most underpriced and that have top momentum, the average monthly return from 1979 to 1996 would have been 3.18 percent, with a monthly Jensen's alpha of about 1.5 percent.

Keywords: Stock Valuation; Book/Market; Earnings/Price; Firm Size; Price Momentum; Stock Returns; Investment Management (search for similar items in EconPapers)
JEL-codes: G10 G12 G13 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-fin
Date: 2004-12-04
Note: Type of Document - pdf; pages: 54

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Persistent link: http://EconPapers.repec.org/RePEc:wpa:wuwpfi:0412007

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