Professional Documents
Culture Documents
Financial Ratios
Jonathan Lewellen
MIT Sloan School of Management Cambridge, MA 02142, USA
Presented by
Deepan Kumar Das
Introduction
▪ The article studies whether the financial ratios: DY, B/M and
E/P can predict aggregate stock returns.
▪ The author uses 03 separate models to come to a decision
on the predictability of the ratios.
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A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 2
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Context and Motivation
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A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 3
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Context and Motivation
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Context and Motivation
Fama and French (1988) find that DY predicts monthly NYSE returns from
1941–1986, with t-statistics between 2.20 and 3.21.
Stambaugh (1986) and Mankiw and Shapiro (1986) show that DY’s predictive
regressions can be severely biased, and their study can understate DY’s
significance.
Kothari and Shanken (1997) and Pontiff and Schall (1998) conclude that B/M has
little predictive power after 1960, and Lamont (1998) finds no evidence that E/P,
predicts quarterly returns from 1947–1994.
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Research Questions
– Sources of data
– Period of market returns samples
– Impact of unusual market conditions
– Requirement of sub-samples to check robustness
– Developing models
– Ways to improve predictability and correct bias
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A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 6
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Contributions in the Research
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Research Models
𝑟𝑡 = 𝛼 + 𝛽𝑥𝑡−1 + 𝜀𝑡 … (𝐸𝑞. 1)
where 𝑟𝑡 is the return in month 𝑡 and 𝑥𝑡−1 is a predictive variable (DY,
B/M or E/P) known at the beginning of the month
▪ The predictive variable 𝑥𝑡−1 is assumed to follow a stationary AR1 process:
𝑥𝑡 = ∅ + 𝜌𝑥𝑡−1 + 𝜇𝑡 … (𝐸𝑞. 2)
where 𝜌 < 1
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Research Models
▪ To correct this problem, the coefficient of the base model 𝛽 can be adjusted
to correct for the interdependent relationship between the ratios and
market returns.
▪ This unconditional adjustment to the base model tends to eliminate any
predictive relationship between ratios and stock market returns in previous
studies.
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A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 9
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Research Models
Tuesday, January
A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 10
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Research Models
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Research Models
▪ The predictive regression model uses natural log of DY, B/M and E/P
measured on the value-weighted NYSE index so that it can have
better time series properties. Also, taking log eliminates skewness
and volatility, which approximates a normal distribution.
▪ Hence, the base model is: 𝑟𝑡 = 𝛼 + 𝛽 𝐿𝑜𝑔(𝐷𝑌𝑡−1 ) + 𝜀𝑡
▪ The stationary AR1 process: 𝐿𝑜𝑔(𝐷𝑌𝑡 ) = ∅ + 𝜌 𝐿𝑜𝑔(𝐷𝑌𝑡−1 ) + 𝜇𝑡
▪ Similarly B/M and E/P follows the above equations with natural log.
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Research Methodology
▪ Sources of Data
– Prices and dividends come from the Center for Research in Security
Prices (CRSP) database
– Earnings and book values come from Compustat (a database of financial,
statistical and market information under the division of S&P Capital IQ)
– Focus on NYSE equal- and value-weighted indices to be consistent with prior
research
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Research Methodology
▪ Scope
– Tests with DY focus on the period from January 1946 to December 2000
– Omission of Depression era because of unusual properties of stock prices prior
to 1945
– Splitting the sample in half and look at the two subperiods:
1946–1972 and 1973–2000
– Investigation of the influence of 1995-2000 period because of unusual stock
returns
– Tests with B/M and E/P are restricted to the Compustat era: 1963–2000
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Research Methodology
▪ Scope
– DY defined as dividends paid over the prior year divided by the current level of
the index. Use of value-weighted DY to predict returns on both the equal- and
value-weighted indices
– B/M defined as the ratio of book equity for the previous fiscal year to market
equity in the previous month
– E/P defined as the ratio of operating earnings (before depreciation) in the
previous fiscal year to market equity in the previous month. Use of operating
earnings as preliminary tests suggests they are a better measure
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Research Methodology
▪ Scope
– Excess returns are calculated as EWNY and VWNY minus the one-month T-bill
rate.
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Research Methodology
▪ Combination of Tests
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Obtained Results & Implications
▪
Marginal, or unconditional,
distribution of 𝛽መ
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Obtained Results & Implications
▪ Joint distribution of 𝛽መ
and 𝜌ො
𝛽መ𝑎𝑑𝑗 = 𝛽መ − 𝛾(𝜌ො − 𝜌)
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Obtained Results & Implications
▪ Panel A
▪ Panel B
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Obtained Results & Implications
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Obtained Results & Implications
Strong evidence of
predictability is apparent.
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Obtained Results & Implications
The table reports
AR1 regressions
for DY and
predictive
regressions for
stock returns for
two periods.
The tests
strongly reject
the null in most
cases showing
great
predictability.
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Obtained Results & Implications
The table reports AR1 regressions for DY and
predictive regressions for stock returns for
two periods, January 1946–December 1994
(588 months) and January 1946–December
2000 (660 months).
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Obtained Results & Implications
The table reports AR1
regressions for the E/P
ratio and predictive
regressions for stock
returns for two periods.
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Summery of the Implications
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Summery of the Implications
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Summery of the Implications
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Thank You…
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