Finance and accounting researchers, analysts and investors have great interest in examining the intrinsic value of a company, the parameters that affect this value and the role of accounting numbers in the valuation process. Intrinsic valuation assumes that a firms’ value is a function of its expected future payoffs to common shareholders, based on currently available information, and the risk inherent in these payoffs. A number of models have been developed in the literature try to estimate the fundamental or intrinsic value of firm, providing a link between market values and accounting numbers. Much of the research into this area makes reference to the residual income model (RIM) and the seminal work of Ohlson (1991, 1995) and Feltham and Ohlson (1995).
The RIM provides a theoretical framework linking accounting information to the intrinsic value of a firm, by stating that a firms’ value is the sum of its book value and the present value of the expected future residual income. However, the RIM is an application of the Dividend Discount Model and its development cannot be attributed to Ohlson (1995). Dechow et al. (1999) and Lo and Lys (2000) point out that the real contribution of Ohlson comes from his modelling of the linear information dynamics.
This paper examines the fundamental value (V) of a sample stock using the residual income model, on the basis of forecasts for the cost of equity, book value, dividend pay-out ratio and return on equity (ROE) and tests its usefulness in predicting cross-sectional stock returns. Furthermore, an intrinsic value risk factor is constructed in such a manner as to obtain a monotonic relationship between risk and expected returns. We do so by creating a zero-investment portfolio that takes long positions in stocks that have high value/price (V/P) ratios and short positions in stocks with low V/P ratios.
Using a dataset collected from Bloomberg data base from Portugal - Euronext Lisbon, Italy - Borsa Italiana, Greece - Athens Stock Exchange and Spain - Borsa de Madrid (PIGS) 2000 to 2016, the article's objective is examined under different macroeconomic conditions. The empirical results documented a positive statistically significant relationship between stock returns and the market risk premium, the size factor and the intrinsic value risk factor. This relationship was negative for the book value factor. Furthermore, the inclusion of the intrinsic value risk factor in the asset pricing models enhanced their predictive ability.