Risk-adjusted equity valuation and expected returns

Finance & Accounting

Further details

In this paper we develop a general equity valuation and return model where fundamental accounting items, interest rates and the discount factor evolve stochastically. We demonstrate that when pricing kernel risk depends on short term interest rates and one market risk factor then book value, abnormal earnings, 'other information' and two risk adjustment terms are sufficient for valuation. Valuation weights and the risk adjustment terms reflect the linear information dynamics parameters. The risk adjustment terms also depend on accounting betas, reflecting the covariances between abnormal earnings and (i) the short interest rate and (ii) the market risk factor. We show that expected stock returns are related to accounting fundamentals, scaled by market price.