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Stock Valuation and Investment Strategies

Author

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  • Zhiwu Chen

    (Yale University - International Center for Finance)

  • Ming Dong

    (York University - Schulich School of Business)

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.

Suggested Citation

  • Zhiwu Chen & Ming Dong, 2004. "Stock Valuation and Investment Strategies," Finance 0412007, EconWPA.
  • Handle: RePEc:wpa:wuwpfi:0412007 Note: Type of Document - pdf; pages: 54
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    References listed on IDEAS

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    Cited by:

    1. Ming Dong & David Hirshleifer, 2005. "A Generalized Earnings-Based Stock Valuation Model," Manchester School, University of Manchester, vol. 73(s1), pages 1-31, September.
    2. 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.
    3. Bakshi, Gurdip & Chen, Zhiwu, 2005. "Stock valuation in dynamic economies," Journal of Financial Markets, Elsevier, pages 111-151.
    4. Gerhard Kling & Utz Weitzel, 2010. "Endogenous mergers: bidder momentum and market reaction," Applied Financial Economics, Taylor & Francis Journals, pages 243-254.
    5. Alvaro Montenegro, 2006. "La información bursátil en Colombia," DOCUMENTOS DE ECONOMÍA 003031, UNIVERSIDAD JAVERIANA - BOGOTÁ.

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    Keywords

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

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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