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Forecasting Cross-Section Stock Returns using Theoretical Prices Estimated from an Econometric Model

It is now widely accepted that cross section stock returns can be forecast by the ratio of the current stock price to a number of accounting variables. For example it has been shown that returns can be forecast by the ratio of the market value to the book value of assets, Fama and French (1992), the price dividend ratio, Elton et al (1983), and the ratio of cash flow to market value of equity, Lakonishok et al (1994). Even the well known size effect, Banz (1981), falls into this class, since size is usually measured by stock price multiplied by the number of outstanding shares.

However what remains unsettled is the question of whether the evidence that price scaled accounting variables can forecast returns indicates a rejection of efficient markets. Is this a genuine profit opportunity or do the return differentials instead rationally reflect risk differences between stocks?

This latter interpretation follows from the fact that risky stocks, which must offer higher expected returns, will inevitably have relatively low market prices relative to accounting variables like book value, current dividends, current earnings and the number of outstanding shares.

In the case of the price dividend ratio this follows immediately from the Gordon growth model. Berk (1996) develops a formal model which demonstrates that in an efficient market both size and market to book will be proxies for risk and hence will forecast returns. Fama and French (1995) report empirical evidence for the efficient markets interpretation by showing that fluctuations in book to market are rational since they are correlated with subsequent earnings growth.

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Forecasting Cross-Section Stock Returns using Theoretical Prices Estimated from an Econometric Model