Fundamentals-Based Risk Measurement in Valuation

ABSTRACT: We propose a methodology to incorporate risk measures based on economic fundamentals directly into the valuation model. Fundamentals‐based risk adjustment in the residual income valuation model is captured by the covariance of ROE with market‐wide factors. We demonstrate a method of estimating covariance risk out of sample based on the accounting beta and betas of size and book‐to‐market factors in earnings. We show how the covariance risk estimate can be transformed to obtain the fundamentals‐based cost of equity. Our empirical analysis shows that value estimates based on fundamental risk adjustment produce significantly smaller deviations from price relative to the CAPM or the Fama‐French three‐factor model. We further find that our single‐factor risk measure, based on the accounting beta alone, captures aspects of risk that are indicated by the book‐to‐market factor, largely accounting for the “mispricing” of value and growth stocks. Our study highlights the usefulness of accounting numbers i...