Explaining the Beta, Size and Value Effects Under the Relative Value Theory
The RVT predicts equilibrium prices in a world where investors ignore variance and only care about cumulative returns. Such prices determine intrinsic returns that satisfy the CAPM equation. This paper shows that assets that pay a constant (or constantly increasing) dividend but face each year the possibility of going bankrupt will exhibit asset specific cumulative returns. These returns depend not only on beta but also on the probability of survival and the growth rate. The derived equations explain the beta, size and value effects previously documented by several authors. Surprisingly, the RVT predicts slightly higher discount rates than the CAPM. Empirical evidence supporting the CAPM cannot reject the RVT at a significant level of confidence. The RVT explains cumulative returns better than alternative models, using a lighter set of assumptions.
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