Is V/P a distinct anomaly?

Abstract

Purpose

Frankel and Lee (1998) report significant abnormal security returns to a trading strategy based on the ratio of the intrinsic value to the market value of common equity (V/P). However, they measure the intrinsic value estimates based on the residual income model using several fundamental variables that have been documented to be associated with subsequent abnormal stock returns. The purpose of this paper is to test whether combining all these individual anomalies to V/P has generated additional predictive power, and whether the abnormal returns related to V/P are due to thepredictive ability of the residual income model or to that of the components used in constructing V/P.

Design/methodology/approach

Two methods are used in this study to examine V/P's incremental effect. First, all the component variables of V/P are included in the same regression with V/P to test whether the coefficient of V/P remains significant. Second, an alternative ex ante transformation of the same component variables is developed and a test is conducted to see whether the trading profits based on V/P and the ex ante transformation differ.

Findings

Overall, the paper finds that V/P does not provide additional explanatory power for subsequent abnormal returns over its component variables, especially analyst forecasts of earnings. The results imply that the source of the delayed security returns related to V/P is the biases in investors' expectations regarding the constituent anomaly variables.

Originality/value

This paper shows that V/P is not a distinct market anomaly. This finding is important to various stock market participants.

Citation

Xu, L.(E). (2007), "Is V/P a distinct anomaly?", Review of Accounting and Finance, Vol. 6 No. 4, pp. 404-418. https://doi.org/10.1108/14757700710835069