Residual Income Valuation and Stock Returns: Evidence from a Value-to-Price Investment Strategy

Abstract

We hypothesize that portfolio sorts based on the V/P ratio generate excess returns and consist of companies that are undervalued for prolonged periods. Results, for the US market show that high V/P portfolios outperform low V/P portfolios across horizons extending from one to three years. The V/P ratio is positively correlated to future stock returns after controlling for firm characteristics, which are well known risk proxies. Findings also indicate that profitability and investment add explanatory power to the Fama and French three factor model and for stocks with V/P ratio close to 1. However, these factors cannot explain all variation in excess returns especially for years two and three and for stocks with high V/P ratio. Finally, portfolios with the highest V/P stocks select companies that are significantly mispriced relative to their equity (investment) and profitability growth persistence in the future.