Fundamental Valuation and Abnormal Returns: An Empirical Comparison of Fundamental Valuation Models

Abstract: This paper empirically compares three different fundamental valuation models - AEG, DDM and RIV - by examining the models' abilities to predict future abnormal returns. Previous research on the comparison of fundamental valuation models assumes that the market is efficient in the semi-strong form and therefore focuses on the models' abilities to predict stock prices at the valuation date. By focusing on the ability to predict future returns, this paper opens up for the possibility that the market might not be efficient in the semi-strong form, without relying on an assumption of market inefficiency. We find that DDM and RIV are able to predict future returns, whereas AEG can only predict returns to the long portfolios, mainly due to its inability to value high-ROE stocks with rapid mean reversion of ROE. Furthermore, portfolios of stocks deemed undervalued generate positive abnormal returns which cannot be explained by risk factors such as correlation with the market index, B/P, or size. In addition, portfolios of the undervalued stocks have lower risk measures than the portfolios of overvalued stocks, despite yielding greater returns. Even though the possibility of an unobservable risk factor cannot be ruled out, our findings indicate a value premium that raises questions regarding market efficiency.