A Theory of Firm Characteristics and Stock Returns: The Role of Investment-Specific Shocks
AbstractWe provide a theoretical model linking firm characteristics and expected returns. The key ingredient of our model is technological shocks embodied in new capital (IST shocks), which affect the profitability of new investments. Firms' exposure to IST shocks is endogenously determined by the fraction of firm value due to growth opportunities. In our structural model, several firm characteristics - Tobin's Q, past investment, earnings-price ratios, market betas, and idiosyncratic volatility of stock returns – help predict the share of growth opportunities in the firm's market value, and are therefore correlated with the firm's exposure to IST shocks and risk premia. Our calibrated model replicates: i) the predictability of returns by firm characteristics; ii) the comovement of stock returns on firms with similar characteristics; iii) the failure of the CAPM to price portfolio returns of firms sorted on characteristics; iv) the time-series predictability of market portfolio returns by aggregate investment and valuation ratios; and v) a downward sloping term structure of risk premia for dividend strips. Our model delivers testable predictions about the behavior of firm-level real variables – investment and output growth – that are supported by the data.
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Bibliographic InfoPaper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 17975.
Date of creation: Apr 2012
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Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.
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Find related papers by JEL classification:
- E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Capital; Investment; Capacity
- E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
This paper has been announced in the following NEP Reports:
- NEP-ALL-2012-04-17 (All new papers)
- NEP-FMK-2012-04-17 (Financial Markets)
- NEP-MAC-2012-04-17 (Macroeconomics)
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- Kraft, Holger & Schwartz, Eduardo & Weiss, Farina, 2013. "Growth options and firm valuation," SAFE Working Paper Series 6, Center of Excellence SAFE - Sustainable Architecture for Finance in Europe, Goethe University Frankfurt.
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