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

This paper contributes to the accounting and asset pricing anomalies literature by investigating the performance of value‐to‐price (V/P) strategies, and the relationship between V/P ratio and various risk proxies. If the V/P ratio successfully predicts future returns at stock level, we hypothesize that portfolios based on the V/P ratio generate excess returns and consist of companies that are undervalued for extended periods. Both overlapping and non‐overlapping returns are used to test the risk/mispricing explanation of the V/P strategy. Results for the US market show that high V/P portfolios outperform low V/P portfolios across horizons extending from 1 to 3 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–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 2 and 3 and for stocks with high V/P ratios. 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.