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Classic Research: Separating Cash Flow and Discount Rate Contributions to Stock Returns

| | Posted in: Size Effect, Value Premium

We have selected for retrospective review a few all-time “best selling” research papers of the past few years from the General Financial Markets category of the Social Science Research Network (SSRN). Here we summarize the August 2003 paper entitled “Bad Beta, Good Beta” (download count over 1,700) by John Campbell and Tuomo Vuolteenaho. In this research, the authors separate stock beta into two components, one reflecting news about cash flows and one reflecting news about discount rates. They apply this decomposition to explain the size effect and the value premium. They hypothesize that:

[Market] “value…may fall because investors receive bad news about future cash flows; but it may also fall because investors increase the discount rate…that they apply to these cash flows. In the first case, wealth decreases and investment opportunities are unchanged, while in the second case, wealth decreases but future investment opportunities improve. …[A]n investor may demand a higher premium to hold assets that covary with the market’s cash-flow news than to hold assets that covary with news about the market’s discount rates, for poor returns driven by increases in discount rates are partially compensated by improved prospects for future returns. …The required return on a stock is determined not by its overall beta with the market, but by its bad cash-flow beta and its good discount-rate beta. Of course, the good beta is good not in absolute terms, but in relation to the other type of beta.” [Underlining is ours.]

Using monthly returns from an early period (January 1929 through June 1963) and a modern period (July 1963 through December 2001) to test this idea, the authors conclude that:

  • Discount-rate news causes much more variation in monthly stock returns than cash-flow news. Discount-rate news drives a standard deviation of 5% per month in market returns, compared to only 2.5% for cash-flow news. However, returns generated by cash-flow news are never subsequently reversed, while those generated by discount-rate news are offset in the future.
  • Value stocks outperform growth stocks in both periods. In the modern period, growth stocks have high betas, but these betas are predominantly good discount-rate beta, and value stocks have higher bad betas than growth stocks. In the early period, value stocks have even higher bad betas than growth stocks.
  • Small stocks outperform large stocks by about 3% per year in both periods. In the modern period, small and large stocks have approximately equal cash-flow betas, but small stocks have much higher discount-rate betas than large stocks. In the early period, small stocks have higher cash-flow and discount-rate betas than large stocks.
  • Assuming that the typical long-term investor is moderately risk-averse, these results explain the small-stock premium and value premium as compensations for higher levels of risk.

In summary, separating stock returns into those driven by changes in cash flow and those driven by changes in the discount rate helps explain the size effect and the value premium.

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