Prediction of ROE and the Residual Income Valuation Model: Forecasting and Modeling Mispricing in the Swedish Stock Market

Using Swedish data, the study investigates whether an investment strategy based on publicly available financial statement information can generate abnormal investment returns. The strategy involves two steps. First, a financial statement based prediction model of changes in the book return on owners’ equity (ROE) is estimated. Second, stock market expectations of changes in ROE are assessed based on observed market prices and the residual income valuation model. Market positions are taken when the financial statement based predictions of ROE and market expectations differ. Over the period 1983–2003, the investment strategy generated an average market-adjusted hedge return of 48.4 % over 36-month holding periods. About half of the returns appear to be due to forecasting mispricing (i.e. stock prices failing to reflect financial statement based predictions of ROE), leaving the remainder to be caused by modeling mispricing (i.e. stock prices failing to reflect the valuation impact of predicted ROE values). However, additional analyses show that the hedge returns in the main are caused by the long position, and that the returns have been affected by a positive market sentiment bias (i.e. positive ROE surprises priced as being more permanent than negative ROE surprises) over the period. Furthermore, most of the positive investment returns accrued over holding periods up to around 1995, with no indications of market mispricing over the last third of the investment period.