Follow us on LinkedIn
In a previous post, we highlighted an article that showed how useful accounting numbers are. In this post, we will present a concrete example of an application of accounting numbers in portfolio management.
Reference [1] showed that the Price-to-Earnings ratio is a mean-reverting process, and it can be accurately estimated by AR(1), an econometric model. Earnings, on the other hand, follow a trend process and can be modeled by a first-order integrated process with a constant factor that captures relative earnings growth.
I propose a model of expected returns by decomposing stock price into two constituents: earnings and price-to-earnings (PE) ratio. The PE ratio is a mean-reverting process that can be forecasted for short to medium horizons. On the other hand, earnings follow a trend process and can be characterized by a first-order integrated process. Growth in earnings is responsible for the growth of stock prices, but the cyclical nature of the PE process imparts time-series predictability to prices.
After calibrating the models, the author constructed a long-only investment strategy that switches between stocks and bonds.
Using the expected return model, I propose a portfolio switching strategy where investor switches between stocks and bonds based on current expected returns on market-wide stock index and risk-free government bond yields. My strategy provides better risk-adjusted returns by avoiding equity investments in periods of low expected returns. The strategy is suitable for retail investors because it only involves market-wide stock index and bond yield. Moreover, my strategy does not require short-selling of stocks which can be difficult for retail investors.
In short, accounting numbers can be used in econometric models in order to develop an asset allocation strategy that offers better risk-adjusted returns.
The article showed that Earnings and Price-to-Earnings ratio have practical and useful applications. In our opinion, revenue and revenue growth are also important accounting numbers that can be used effectively in portfolio management.
References
[1] N. Vidhani, Return Predictability using Price-to-Earnings Ratio, 2021, https://ssrn.com/abstract=3910641
Further questions
What's your question? Ask it in the discussion forum
Have an answer to the questions below? Post it here or in the forum
Ukrainian soldiers are training to shoot at Russian drones without the help of Western weaponry.
Australia is on track to cut its greenhouse emissions by 42% below 2005 levels by 2030, Climate and Energy Minister Chris Bowen said, citing new projections that will be released formally this week.
