The authors propose using intrinsic value (defined as equity book value plus the present value of future economic profits) as an alternative for measuring fundamentals. This approach produces significant alpha when applied to historical data.
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Abstract
The paper proposes to use intrinsic value as an alternative measure of fundamentals in predicting stock returns. We construct intrinsic value as the sum of the book value of equity and the present value of future economic profits. The capital asset pricing model alpha of a long-short portfolio of large stocks based on the intrinsic-value-to-market ratio is 56 bps per month between 1999 and 2023 when the book-to-market ratio and similarly constructed price multiples fail to predict returns. We argue that the underperformance of strategies based on traditional valuation multiples stems from their failure to model future economic profits, which have become a more significant component of firm value as discount rates have decreased.