Earnings-consumption betas and stock valuation

Abstract

This paper integrates the long-run covariance between aggregate consumption and firm earnings into the stock valuation process. After assuming that firms adjust their dividend payments toward a target dividend payout ratio, we use the intertemporal framework of the consumption capital asset pricing model (CCAPM) to explore the effect of systematic earnings risks on intrinsic stock values. Our main results show that the equilibrium price of a stock is positively related to its long-run earnings growth rate, and negatively related to its earnings-consumption beta, obtained from its long-run covariance between earnings growth and aggregate consumption growth. This suggests that long-run risk measured with earnings affects the theoretical value of a firm. Overall, our work suggests that the long-run concept of risk, using accounting earnings, represents an appropriate parameter for estimating the equity value of a firm.

Consumption, earnings risk, and payout ratios

“…Also, as Ball and Sadka (2015, p. 51) mention, "In sum, while the empirical evidence to date is scant, these studies suggest that studying systematic earnings risk is a promising avenue for further research." In line with this suggestion, Bergeron et al (2018) demonstrate that the covariance between earnings and aggregate consumption affects the intrinsic value of a firm.…”

“…Moreover, it supports the existence of an optimal dividend policy, in an intertemporal context. The present paper can be viewed as a direct extension of Bergeron et al (2015) and Bergeron et al (2018). The first paper examines the theoretical relationship between the multidimensionality of risk and dividend policy, in an intertemporal context.…”