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Stock Valuation and Investment Strategies

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  • Zhiwu Chen
  • Ming Dong

Abstract

This article studies the relative investment performance of several stock-valuation measures. The first is mispricing based on the valuation model developed by Bakshe and Chen (1998)and extended by Dong (1998) (hereafter, the BCD model). The BCD model relates, in closed form, a stock's fair value to (i) the firm's net earnings per share (EPS). (ii) the expected future EPS growth and (iii) long-term rate. The second is a value/ price (V/P) ratio based on the Lee-Myers-Swaminathan (1999) residual-income model. The other measures are all indirect valuation indicators, including book/market (B/M), earnings/price (E/P), size, and past return momentum. These measures are shown to possess distinct properties. For example, the B/M, E/P and V/P ratios are highly persistent over time: high (low) B/M stocks tend to maintain high (low) B/M ratios. But, the BCD model mispricing is highly mean-reverting: an overpriced group will eventually become underpriced (in about 1.5 years on average), and vice versa. More importantly, the BCD model mispricing, momentum, size V/P and B/M are, in decreasing order, significant ex ante predictors of future returns. The best investment strategy is to combine the BCD model mispricing with momentum rankings. Indeed, if one would hold an equally-weighted portfolio of stocks that are the most underpriced and that have top momentum, the average monthly return from 1979 to 1996 would have been 3.18 percent, with a monthly Jensen's alpha of about 1.5 percent.

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Bibliographic Info

Paper provided by Yale School of Management in its series Yale School of Management Working Papers with number ysm212.

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Date of creation: 01 Jul 2001
Date of revision: 01 Oct 2001
Handle: RePEc:ysm:somwrk:ysm212

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Web page: http://icf.som.yale.edu/
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Related research

Keywords: Stock Valuation; Book/Market; Earnings/Price; Firm Size; Price Momentum; Stock Returns; Investment Management;

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Cited by:
  1. Gerhard Kling & G.U. Weitzel, 2009. "Endogenous mergers: bidder momentum and market reaction," Working Papers 09-22, Utrecht School of Economics.
  2. Ming Dong & David Hirshleifer, 2004. "A Generalized Earnings-Based Stock Valuation Model," Finance 0412008, EconWPA.
  3. Zhiwu Chen & Jan Jindra, 2001. "A Valuation Study of Stock-Market Seasonality and Firm Size," Yale School of Management Working Papers ysm199, Yale School of Management.
  4. Zhiwu Chen & Gurdip Bakshi, 2001. "Stock Valuation in Dynamic Economics," Yale School of Management Working Papers ysm198, Yale School of Management.
  5. Bakshi, Gurdip & Chen, Zhiwu, 2005. "Stock valuation in dynamic economies," Journal of Financial Markets, Elsevier, vol. 8(2), pages 111-151, May.
  6. Alvaro Montenegro, 2006. "La información bursátil en Colombia," DOCUMENTOS DE ECONOMÍA 003031, UNIVERSIDAD JAVERIANA - BOGOTÁ.

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