The Predictive Ability of Valuation Measures and the Cross-section of Stock Returns

Several studies evaluate the ability of certain valuation measures to explain stock prices. But only a few examine the predictive power of the valuation measures for cross-sectional stock returns. The main objectives of the present paper are: a) to further develop equity valuation measures by incorporating the methodology of simulation in a residual income model, and b) to examine whether the resulting value-to-price (V/P) ratio can be related to the efficiency of the market and the predictability of cross-sectional stock returns. The dataset uses is from Eurozone countries, which to the best of our knowledge has not been used in the past. The simulation approach is used to obtain forecasts for the main parameters of the valuation measures. Furthermore, it will be examined whether the resulting V/P ration can be related to the efficiency of the market and the predictability of cross-sectional stock returns. The research design, that incorporates Monte Carlo simulation, features a more robust valuation model than simple market-multiples leading to better predictions of cross-sectional stock returns.