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The Usefulness of Book-to-Market and ROE Expectations for Explaining UK Stock Returns

Authors

  • Colin Clubb,

    1. The authors are respectively from Warwick Business School, University of Warwick; and Citigroup.
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  • Mounir Naffi

    Corresponding author
    1. The authors are respectively from Warwick Business School, University of Warwick; and Citigroup.
      * Address for correspondence: Colin Clubb, Accounting Group, Warwick Business School, University of Warwick, Coventry, CV4 7AL, UK. e-mail: colin.clubb@wbs.ac.uk
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  • This paper has been presented at the Contemporary Issues in Capital Markets Conference at the University of Cyprus in September 2004, the 2005 British Accounting Association Annual Conference at Herriot Watt University, the 2005 European Accounting Association Annual Congress in Gothenburg and seminars at the University of Exeter and the University of Warwick. The paper has benefited from very helpful suggestions by Andy Stark and from the comments of Andreas Charitou, Ray Donnelly, Dirk Nitzche, Lenos Trigeorgis and an anonymous referee. Mounir Naffi worked on this paper as part of his PhD thesis at the Tanaka Business School, Imperial College London before joining Citigroup.

* Address for correspondence: Colin Clubb, Accounting Group, Warwick Business School, University of Warwick, Coventry, CV4 7AL, UK. e-mail: colin.clubb@wbs.ac.uk

Abstract

Abstract:  The fundamental valuation perspective on stock returns suggests that book-to-market will be positively related to returns if market value of equity equals future expected cash flows discounted at the expected return and book value proxies for future cash flows. Building on this perspective, we develop a log linear model which includes expectations of future BM and ROE in addition to current BM as explanatory variables for future stock returns. We show that these three variables explain a significant part of UK cross-sectional stock returns and that they remain highly statistically significant after including additional risk proxy variables. This supports relevance of fundamental valuation based firm characteristics for explaining stock returns and indicates their potential usefulness for predicting future stock returns.

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