Stock Valuation and Learning about Profitability

Authors

  • Ľuboš Pástor,

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    • Both authors are at the Graduate School of Business, University of Chicago. Both are also affiliated with the CEPR and NBER. Helpful comments were gratefully received from Dan Bens, Tony Bernardo, Michael Brennan, John Campbell, George Constantinides, Gene Fama, Ken French, Chris Geczy, Rick Green, John Heaton, Boyan Jovanovic, Rob Stambaugh, Per Strömberg, Tuomo Vuolteenaho, Larry Wall, Franco Wong, Yihong Xia, an anonymous referee, and seminar participants at the Federal Reserve Bank of Atlanta, the Federal Reserve Bank of Chicago, the University of Chicago, the University of Pennsylvania, and the 2002 ESSFM (CEPR) at Gerzensee.
  • Veronesi Pietro

    Search for more papers by this author
    • Both authors are at the Graduate School of Business, University of Chicago. Both are also affiliated with the CEPR and NBER. Helpful comments were gratefully received from Dan Bens, Tony Bernardo, Michael Brennan, John Campbell, George Constantinides, Gene Fama, Ken French, Chris Geczy, Rick Green, John Heaton, Boyan Jovanovic, Rob Stambaugh, Per Strömberg, Tuomo Vuolteenaho, Larry Wall, Franco Wong, Yihong Xia, an anonymous referee, and seminar participants at the Federal Reserve Bank of Atlanta, the Federal Reserve Bank of Chicago, the University of Chicago, the University of Pennsylvania, and the 2002 ESSFM (CEPR) at Gerzensee.

Abstract

We develop a simple approach to valuing stocks in the presence of learning about average profitability. The market-to-book ratio (M/B) increases with uncertainty about average profitability, especially for firms that pay no dividends. M/B is predicted to decline over a firm's lifetime due to learning, with steeper decline when the firm is young. These predictions are confirmed empirically. Data also support the predictions that younger stocks and stocks that pay no dividends have more volatile returns. Firm profitability has become more volatile recently, helping explain the puzzling increase in average idiosyncratic return volatility observed over the past few decades.

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