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A Theory of Firm Characteristics and Stock Returns: The Role of Investment-Specific Shocks

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  • Leonid Kogan
  • Dimitris Papanikolaou

Abstract

We 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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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 17975.

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Date of creation: Apr 2012
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Publication status: published as Kogan, L., D. Papanikolaou, 2013, “Firm Characteristics and Stock Returns: The Role of Investment-Specific Shocks.” Review of Financial Studies, 26, 2718-2759.
Handle: RePEc:nbr:nberwo:17975

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Citations

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Cited by:
  1. Michael Weber, 2014. "Nominal Rigidities and Asset Pricing," 2014 Meeting Papers 53, Society for Economic Dynamics.
  2. Kraft, Holger & Schwartz, Eduardo & Weiss, Farina, 2013. "Growth options and firm valuation," SAFE Working Paper Series 6, Research Center SAFE - Sustainable Architecture for Finance in Europe, Goethe University Frankfurt.
  3. Frederico Belo & Pierre Collin-Dufresne & Robert S. Goldstein, 2012. "Endogenous Dividend Dynamics and the Term Structure of Dividend Strips," NBER Working Papers 18450, National Bureau of Economic Research, Inc.
  4. Lu Zhang & Howard Kung & Hang Bai, 2013. ""Shooting" the CAPM," 2013 Meeting Papers 905, Society for Economic Dynamics.
  5. Holger Kraft & Eduardo S. Schwartz & Farina Weiss, 2013. "Growth Options and Firm Valuation," NBER Working Papers 18836, National Bureau of Economic Research, Inc.
  6. Leonid Kogan & Dimitris Papanikolaou & Noah Stoffman, 2013. "Technological Innovation: Winners and Losers," NBER Working Papers 18671, National Bureau of Economic Research, Inc.

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