Stock Return Predictability of Residual‐Income‐Based Valuation: Risk or Mispricing?

In an influential paper, F rankel and L ee (1998) conclude that the stock return predictability of the value‐to‐price ratio ( V / P ) results from market mispricing. This paper confirms whether the V / P reflects the rational risk premiums associated with the V / P factor or is better explained by market inefficiency. Following D aniel and T itman (1997), this paper examines whether the V / P characteristics or the V / P factor loadings predict stock returns. The findings show that the V / P loadings are positively associated with average returns even after controlling for the V / P characteristics in both time series and cross‐sectional tests. The overall results suggest that the mispricing explanation of the V / P effect is premature.