Consumption-Based Equity Valuation

Abstract

Using a CCAPM-based risk-adjustment model, we perform yearly valuations of a large sample of stocks listed on NYSE, AMEX and NASDAQ over a thirty-year period. The model differs from standard valuation models in the sense that it adjusts forecasted residual income for risk in the numerator rather than through a risk-adjusted cost of equity in the denominator. The risk-adjustments are derived based on assumptions about the time-series properties of residual income returns and aggregate consumption rather than on historical stock returns. We compare the performance of the model with several implementations of standard valuation models, both in terms of median absolute valuation errors (MAVE), and in terms of excess returns on simple investment strategies based on the differences between model and market prices.

The CCAPM-based valuation model yields a MAVE of 23%, while the best performing standard valuation model has a MAVE of 36%. Both types of models can identify investment strategies with subsequent excess returns. The CCAPM-based valuation model yields time-series of realized hedge returns with more and higher positive returns and fewer and less negative returns compared with the time-series of realized hedge returns based on the best performing standard valuation model, i.e., higher average realized returns (4.5% versus 3.0%) and higher average Sortino ratios (78% versus 34%) for holding periods from one to five years. In a statistical test of one-year ahead excess return predictability based on the models' implied pricing errors, the CCAPM-based valuation model is selected as the better model with a p-value of 0.0077.

Using the standard series of aggregate consumption and the nominal price index, a reasonable level of relative risk aversion, and calibrated growth rates in the continuing value at each valuation date, the CCAPM-based valuation model produces small risk-adjustments to forecasted residual income and low continuing values. Compared with standard valuation models, it relies less on estimated parameters and speculative elements when aggregating residual earnings forecasts into a valuation.

Keywords: Equity valuation, residual income, risk-adjusted discounting, CAPM, CCAPM

JEL Classification: C22, C32, C51, C53, G11, G12, G14, G32