Accounting-Based Equity Valuation and Returns on Equity Volatility
46 Pages Posted: 29 Nov 2015 Last revised: 8 Mar 2020
Date Written: January 18, 2016
The same firm characteristics that help explain cross-sectional variation in expected stock returns, such as size, book-to-market and the earnings yield, also help explain cross-sectional variation in returns to trading in option-implied stock return volatility. This empirical phenomenon is shown to arise within a tractable accounting-based valuation model that allows for risk aversion and stochastic earnings volatility. The model predicts that expected stock (stock return volatility) returns are positively (negatively) related to a combination of the inverse of size, book-to-market, the earnings yield, and the dividend yield. These predictions are strongly supported using a variety of empirical specifications. The model provides a framework for jointly investing in stocks and options, and the findings highlight the ability of accounting-based valuation models to explain price dynamics across stock and volatility markets.
Keywords: Fundamental Analysis, Valuation, Stock Returns, Variance Risk Premiums, Option Returns
JEL Classification: G12, G14, G17
Suggested Citation: Suggested Citation