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Predicting Returns with

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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Context and Motivation

▪ Common features among the ratios (DY, B/M and E/P):

– Each has price in the denominator:

𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒


DY =
𝑃𝑟𝑖𝑐𝑒 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎 𝐹𝑖𝑟𝑚


B/M =
𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝐹𝑖𝑟𝑚

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑎 𝐹𝑖𝑟𝑚


E/P =
𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝐹𝑖𝑟𝑚

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Context and Motivation

▪ Common features among the ratios (DY, B/M and E/P):

– The ratios should be positively related to expected returns


– They are supposed to predict returns because they can capture information
about risk premium
– They share similar time-series properties:

▪ they have autocorrelations near 1, and


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

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Context and Motivation

▪ Aftermath of previous studies as motivation:

– Prior studies find weak evidence of predictability of market returns:

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

▪ Major research questions cover the following points:

– 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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Contributions in the Research

▪ Showing that small-sample distribution studied by Stambaugh


(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

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Research Models

▪ The base (regression) model [also analyzed by Stambaugh (1986, 1999),


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

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Research Models

▪ For the regression (𝐸𝑞. 1) to be ‘predictive’, the ratios have to be known


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.

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Research Models

▪ Since 𝜀𝑡 and 𝜇𝑡 , from (𝐸𝑞. 1) and (𝐸𝑞. 2) respectively, are negatively


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.

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Research Models

▪ An alternative to the unconditional adjustment:

– Because the autoregressive coefficient cannot be greater than 1, the adjustment


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.

▪ The conditional adjustment to the base model by means of


conditional expectation of 𝛽መ is: Ε 𝛽መ − 𝛽 𝜌ො = 𝛾(𝜌ො − 𝜌)
▪ The bias-adjusted estimator: 𝛽መ𝑎𝑑𝑗 = 𝛽መ − 𝛾(𝜌ො − 𝜌), where 𝜌 ≈ 1

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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

– Estimation of four return variations:


▪ 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.

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Research Methodology

▪ Combination of Tests

– The conditional test is a natural addition to the small-sample distribution


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.

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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

መ with more than 85% of the


– Clearly shows the strong bias and skewness in 𝛽;
estimates being positive

▪ Panel B

– Shows strong correlation between 𝛽መ and 𝜌ො

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Obtained Results & Implications

The table reports summary statistics for


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

Financial ratios are extremely persistent.


The first-order autocorrelations range
from 0.988 to 0.999 for the various series.

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Obtained Results & Implications

The table reports an AR1


regression for DY and
predictive regressions for
stock returns for
the period January 1946–
December 2000 (660
months).

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

The unconditional bias adjusted slopes are


higher than the conditional estimates but their
significance levels are much lower. This finding
points to an odd property of the tests.

For EWNY, the bias-adjusted


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.
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Obtained Results & Implications
The table reports
AR1 regressions for
the B/M ratio and
predictive
regressions for stock
returns for two
periods.

B/M has some


forecasting ability,
but the evidence is
less reliable than for
DY.

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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.

The results for E/P are


similar to those for
B/M. E/P appears to
forecast nominal
returns, but there is
little evidence that it
forecasts excess
returns.

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Summery of the Implications

▪ In case of DY, smaller decrease in the adjusted coefficient under the


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).

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Summery of the Implications

▪ Under the shortened subperiods, the unconditional adjustment did


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.

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Summery of the Implications

▪ Outcomes based on B/M and E/P were not as promising as DY.


▪ 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.

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Thank You…

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