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Predicting Returns with Financial Ratios

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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.

Tuesday, January

A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 2

23, 2018

Context and Motivation

DY =

𝑃𝑟𝑖𝑐𝑒 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

B/M =

𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝐹𝑖𝑟𝑚

E/P =

𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝐹𝑖𝑟𝑚

Tuesday, January

A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 3

23, 2018

Context and Motivation

– They are supposed to predict returns because they can capture information

about risk premium

– They share similar time-series properties:

▪ most of their movement is caused by price changes in the denominator

Tuesday, January

A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 4

23, 2018

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.

Tuesday, January

A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 5

23, 2018

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

Tuesday, January

A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 6

23, 2018

Contributions in the Research

(1986, 1999) and Nelson and Kim (1993) can substantially understate

DY’s predictability

▪ Subsequently evidencing DY’s predictability strongly with a new test

▪ Suggesting that B/M and E/P can predict market returns, which

previous studies failed to establish significantly

Tuesday, January

A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 7

23, 2018

Research Models

Mankiw and Shapiro (1986), and Nelson and Kim (1993)]

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

Tuesday, January

A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 8

23, 2018

Research Models

before the market returns. Also higher returns means increase in prices

which reduce each of the ratios as price is in the denominator. That is why

error terms 𝜀𝑡 and 𝜇𝑡 are negatively correlated. It follows that 𝜀𝑡 is

correlated with 𝑥𝑡 in the predictive regression. Thus it violates the

regression assumption of independence.

▪ 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.

Tuesday, January

A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 9

23, 2018

Research Models

correlated, estimation errors in the two equations are closely connected:

𝛽መ − 𝛽 = 𝛾 𝜌ො − 𝜌 + 𝜂

where 𝜂 is a random error with zero mean and 𝛾 is negative

constant.

▪ Since ratios should be stationary unless there is a bubble in stock prices, a

lower bound on the sampling error in 𝜌 is 𝜌ො − 1, and bias in 𝛽መ is at most

γ(𝜌ො − 1). This upper bound will be less than the standard bias-adjustment if

𝜌ො is close to 1.

▪ Empirical tests that ignore the information in 𝜌ො understate DY’s predictive

power.

Tuesday, January

A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 10

23, 2018

Research Models

to the base model is done by setting the autoregressive coefficient to about 1.0

(or 0.9999). This provides for the largest adjustment to the base model, and

minimizes the value of the adjusted coefficient.

conditional expectation of 𝛽መ is: Ε 𝛽መ − 𝛽 𝜌ො = 𝛾(𝜌ො − 𝜌)

▪ The bias-adjusted estimator: 𝛽መ𝑎𝑑𝑗 = 𝛽መ − 𝛾(𝜌ො − 𝜌), where 𝜌 ≈ 1

Tuesday, January

A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 11

23, 2018

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.

Tuesday, January

A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 12

23, 2018

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

Tuesday, January

A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 13

23, 2018

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

Tuesday, January

A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 14

23, 2018

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

Tuesday, January

A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 15

23, 2018

Research Methodology

▪ Scope

▪ Nominal Value-Weighted Returns (VWNY)

▪ Nominal equal-weighted returns (EWNY)

▪ Excess VWNY, and

▪ Excess EWNY

– Excess returns are calculated as EWNY and VWNY minus the one-month T-bill

rate.

Tuesday, January

A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 16

23, 2018

Research Methodology

▪ Combination of Tests

used by prior studies.

– A simple algorithm is to use both tests and calculate a joint significance level as

it is not possible to say predictably whether the conditional or unconditional

approach is better.

Tuesday, January

A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 17

23, 2018

Obtained Results & Implications

▪

Marginal, or unconditional,

distribution of 𝛽መ

Tuesday, January

A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 18

23, 2018

Obtained Results & Implications

▪ Joint distribution of 𝛽መ

and 𝜌ො

𝛽መ𝑎𝑑𝑗 = 𝛽መ − 𝛾(𝜌ො − 𝜌)

Tuesday, January

A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 19

23, 2018

Obtained Results & Implications

▪ Panel A

– Clearly shows the strong bias and skewness in 𝛽;

estimates being positive

▪ Panel B

Tuesday, January

A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 20

23, 2018

Obtained Results & Implications

stock returns, DY, B/M, and E/P ratio.

The first-order autocorrelations range

from 0.988 to 0.999 for the various series.

Tuesday, January

A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 21

23, 2018

Obtained Results & Implications

regression for DY and

predictive regressions for

stock returns for

the period January 1946–

December 2000 (660

months).

Strong evidence of

predictability is apparent.

Tuesday, January

A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 22

23, 2018

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.

Tuesday, January

A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 23

23, 2018

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).

higher than the conditional estimates but their

significance levels are much lower. This finding

points to an odd property of the tests.

slope actually increases with the addition of

1995–2000 which can be explained by sharp

rise in the sample autocorrelation of DY in that

period.

Tuesday, January

A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 24

23, 2018

Obtained Results & Implications

The table reports

AR1 regressions for

the B/M ratio and

predictive

regressions for stock

returns for two

periods.

forecasting ability,

but the evidence is

less reliable than for

DY.

Tuesday, January

A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 25

23, 2018

Obtained Results & Implications

The table reports AR1

regressions for the E/P

ratio and predictive

regressions for stock

returns for two periods.

similar to those for

B/M. E/P appears to

forecast nominal

returns, but there is

little evidence that it

forecasts excess

returns.

Tuesday, January

A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 26

23, 2018

Summery of the Implications

conditional adjustment procedure than under the unconditional

adjustment procedure is found.

▪ The standard error under the conditional adjustment procedure is

also reduced, thereby increasing the predictive power of the

conditional adjustment model. This has been true for all return

variations.

▪ DY predicted excess market returns in the first subperiod (1946-1972)

and in all four return variations in the second subperiod (1973-2000).

Tuesday, January

A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 27

23, 2018

Summery of the Implications

not do very well whereas the conditional adjustment improved the

predictive power of the models.

▪ To test the impact of the unusual market conditions in the last half of

the 1990s, data were separated in two sub-periods: 1946-1994 and

1946-2000. The unconditional adjustment performed poorly but the

conditional adjustment improved the predictive powers of the

models.

Tuesday, January

A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 28

23, 2018

Summery of the Implications

▪ B/M models were not able to predict either nominal or excess value-

weighted returns. Results for nominal and excess equal-weighted

returns were similar to DY results, with the unconditional adjustment

reducing the predictive power of B/M and the conditional adjustment

improving it.

▪ Results based on E/P indicated a predictive relationship to nominal

market returns, but not for excess returns.

▪ The impact of the 1995–2000 data was less on conditional-adjusted

estimates than on unconditional-adjusted estimates for both the B/M

and E/P models.

Tuesday, January

A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 29

23, 2018

Thank You…

Tuesday, January

A summary on "Predicting returns with financial ratios" presented by Deepan Kumar Das at Brock University 30

23, 2018

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