Stock market trading strategies based on earnings and cash flows in Finland: alternative risk-adjusting approach

This paper investigates whether the predictability of risk-adjusted stock returns using the ratio of earnings to stock price and the ratio of cash flow earnings to stock price disappears, when accounting-based risk measures are used for risk-adjusting purposes. The main contribution of the paper is to extend the approach suggested by Chan and Chen (1991) to other trading strategies and accounting-based risk measures. Consistent with the hypothesis developed, the empirical results indicate that earnings-to-price ratios lose their ability to predict stock returns when a firm's financial and business risks are used to measure the risk of its stock. The results also indicate that these accounting-based risk measures can weaken but not totally negate the ability of the cash-flow earnings to stock price ratio to predict risk-adjusted stock returns.