1. What Drives Firm-Level Stock Returns?
TUOMO VUOLTEENAHO
한 성 호

2. ABSTRACT
By definition, a firm‘s stock returns are driven by shocks to expected cash flow (cash- flow news) and/or shocks to discount rates (expected-return news).
The VAR and Campbell‘s return-decomposition framework enable writer to decompose the firm-level stock return into cash-flow and expected-return news.
The VAR yields three main results.
Firm-level stock returns are mainly driven by cash-flow news.
Shocks to expected returns and cash flows are positively correlated for a typical small stock.
Expected-return-news series are highly correlated across firms, while cash-flow news can largely be diversified away in aggregate portfolios.
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3. I. Decomposing the Stock Return
An accounting-based present-value formula uses ROE instead of dividend growth
as the basic cash-flow fundamental
Three main assumptions (ROE-based version of the present-value model)
Book equity (B), dividend (D), market equity (M) are strictly positive.
The difference between log book equity (b) and log market equity (m) and the difference between log dividend (d) and log book equity are stationary.
Earning (X), dividends, and book equity must satisfy the clean surplus identity -
A model for the log book-to-market ratio (denoted by )
ROE ( ) = log( / )
the excess log stock return ( ) = log( ) -
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4. I. Decomposing the Stock Return
An accounting-based present-value formula uses ROE instead of dividend growth
as the basic cash-flow fundamental
A reorganized model (the change in expectations from t-1 to t)
The unexpected excess stock return can be high if either expected future returns
decrease and/or expected future excess ROEs (ROE less interest rate) increase.
The unexpected-return variance decomposition of a model
The variance decomposition is used to assess the importance of expected-return and
cash-flow news as drivers of stock returns.
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5. II. Data
The basic data come from the CRSP-COMPUSTAT intersection, 1954 to 1996.
Basic Data
Data Requirements
Variable Definitions
Transformations
Descriptive Statistics
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6. III. Results and Discussion
A. Firm-level Variance Decomposition of Market-adjusted Returns
A individual firm‘s state vector
The VAR implies a return decomposition. ( define , )
: expected-return news
: cash-flow news
The variance decomposition of unexpected-return
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7. III. Results and Discussion
A. Firm-level Variance Decomposition of Market-adjusted Returns
The expected future book-to-market ratio is mostly affected by the past book-to-market ratio.
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8. III. Results and Discussion
A. Firm-level Variance Decomposition of Market-adjusted Returns
A cash-flow shock typically coincides with a temporary increase in risk, and hense in equilibrium expected returns.
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9. III. Results and Discussion
A. Firm-level Variance Decomposition of Market-adjusted Returns
The firm-level returns are mainly driven by cash-flow news, but this does not necessarily imply that the expected-return variation is unimportant for firm-level stock prices.
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10. III. Results and Discussion
A. Firm-level Variance Decomposition of Market-adjusted Returns
It is slightly more likely that a stock‘s atypical discount is extremely low than extremely high. While cash-flow news is more important than expected-return news, expected-return variation still has an economically significant impact on firm-level stock prices.
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11. III. Results and Discussion
B. Variance Decomposition of Market-adjusted Returns as a Function of Firm Size
Almost all of the large-stock market-adjusted-return variance is due to cash-flow news.
For small firms, the expected-return and cash-flow news are strongly correlated, while this correlation is approximately zero for large stocks.
Since the covariance term is so large and positive, the estimated small-stock unexpected-return variance is, in fact, slightly lower than the estimated cash-flow-news variance.
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12. III. Results and Discussion
C. Return Response to Cash-flow News
A behavioral-finance interpretation of this result is that the market underreacts to small-stock cash-flow news.
When there is news about the cash flows of a small stock, the price does not move enough. Therefore, expected returns must increase.
The market underreacts to cash-flow news if the two news series are positively correlated.
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13. III. Results and Discussion
D. Implied Variance Decomposition of the Equal-weight Index Portfolio
Similar to the market-adjusted results, the firm-level cash-flow-news variance is larger than the firm-level expected-return-news variance and the news series are positively correlated.
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14. III. Results and Discussion
D. Implied Variance Decomposition of the Equal-weight Index Portfolio
It appears that while cash-flow information is largely firm specific, expected return information is predominantly driven by systematic, macroeconomic components. Hence, my firm-level results are consistent with the earlier aggregate results.
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15. IV. Conclusions
While previous research investigates aggregate portfolois, this paper measures the importance of cash-flow and expected-return news for firm-level stock returns.
Firm-level stock returns are predominantly driven by cash-flow news.
Cash-flow news is positively correlated with shocks to expected- returns for a typical stock. This correlation appears to be larger for smaller stocks.
Cash-flow news is more easily diversified away in portfolios than expected-return news.
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16. Borja Larrain, Motohiro Yogo 120080367 한 성 호
Does firm value move too much to be justified by subsequent changes in cash flow?
Borja Larrain, Motohiro Yogo
한 성 호 16

17. Introduction
Movements in the value of corporate assets can be explained by changes in expected future cash flow.
This paper examines the present-value relation between the asset value and cash flow of US corporations.
The appropriate measure of cash flow for valuing corporate assets is net payout, which is the sum of dividends, interest and net repurchases of equity and debt.
Variation in net payout yield, the ratio of net payout to asset value, is mostly driven by movements in expected cash flow growth, instead of movements in discount rates.
Net payout yield is less persistent than dividend yield and implies much smaller variation in long-horizon discount rates.
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18. Introduction
Our focus on net payout is motivated by three considerations.
A recent literature on corporate payout policy has broadened the scope of payout beyond ordinary dividends.
Difference between the portfolio view and the macro view of investment.
A recent literature that has shown the shortcomings of dividend yield in measuring the magnitude of variation in discount rates.
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19. Empirical framework
We use the firm‘s intertemporal budget constraint to study the present-value relation between net payout and asset value.
The firm‘s intertemporal budget constraint
Present-value relation between net payout and asset value
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20. Empirical framework
We model the joint dynamics of asset return, net payout growth, and net payout yield through a vertor autoregression (VAR).
VAR estimation
The VAR model is overidentified. We estimate the model by GMM. We test the
overidentifying restrictions of the model through the J-test.
Variance decompositions
Variance of net payout yield
Variance of unexpected asset returns
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21. Data on payout, issuance, and asset value
We therefore view the Flow of Funds as our main evidence and Compustat as supporting evidence
Flow of funds data
Compustat data
Description of payout, issuance, and asset value
Description of asset returns
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22. Valuation of corporate assets
Variance decomposition of net payout yield
Net payout yield mostly predicts net payout growth instead of asset returns, especially over long horizons
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23. Valuation of corporate assets
Variance decomposition of net payout yield
The wedge between the two time series represents long-horizon discount rates.
Asset value moves in lockstep with expected future net payout because the variation in hong-horizon discount rates is relatively small
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24. Valuation of corporate assets
The role of debt payout
We loosely refer to the net payout-equity payout ratio as debt payout because net payout minus equity payout is equal to debt payout in levels. The combination of high equity inssuance and high debt repurchase implies much smaller variation in expected returns than that implied by the equity payout-assets ratio alone.
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25. Valuation of corporate assets
Variance decomposition of asset returns
Changes in expected cash flow growth are larger when debt payout is included.
Because net payout includes cash flows to debt holders, changes in expected cash flow growth become a relatively important source of variation in asset retirns.
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26. Valuation of market equity
Description of equity payout yield
Dividend yield is less volatile and more persistent than equity payout yield. Dividend yield is above equity payout yield for most of the sample period, indicating a net capital inflow to the market equity of US corporations.
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27. Valuation of market equity
Variance decomposition of dividend yield
The variance decomposition shows that the transitory variation in discount rates is large relative to the transitory variation in expected dividend growth.
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28. Valuation of market equity
Variance decomposition of equity payout yield
Variance decomposition shows that the transitory variation in discount rates is small relative to the transitory variation in expected equity payout growth.
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29. Valuation of market equity
Variance decomposition of equity payout yield
The wedge between the two time series in Panel B is smaller than the wedge between the two time series in Panel A. Because equity payout yield is less persistent than dividend yield, it implies smaller variation in hong-horizon discount returns.
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30. Valuation of market equity
The role of equity repurchase and issuance
Table 10 explicitly links the two models to clarify the role of equity payout in reducing the magnitude of variation in long-horizon discount rates.
We loosely refer to log equity payout-dividend ratio as net equity repurchase because equity payout minus dividends is equal to net equity repurchase in levels.
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31. Valuation of market equity
Variance decomposition of equity returns
In Panel A, holding constant discount rates, only 38% of the variation in equity returns is explained by changes in expected dividend growth.
In Panel B, holding constant discount rates, at most 61% of the variation in equity returns can be explained by changes in expected equity payout growth. The rest must be explained by variation in discount rates, implying that equity returns cannot be explained entirely by movements in expected cash flow growth.
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32. Conclusions
In this paper, we focus on a different but related question of whether time-varing discount rates are important for the valuation of firms.
Net payout yield, which incorporates net repurchases of both equity and debt, implies small variation in log- horizon discount rates.
The value of corporate assets is mostly driven by changes in expected future cash flow, instead of changes in discount rates.
Therefore, the constant discount rate present-value model is a useful approximation for the valuation of corporate assets.
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