Yufen Fu

Non-Dividend Paying Stocks and the Negative Value Premium

The value premium is the empirical observation that low market/book “value” stocks have higher returns than high market/book “growth” stocks. In this paper, we show that the profitability determined relation between risk and return is distinct for non-dividend paying businesses. High profitability dividend paying stocks have low returns whereas high profitability non-dividend paying stocks have high returns. Since profitability and market values relate positively, dividend paying stocks have a value premium whereas non-dividend paying stocks have a “negative value premium.” We argue that high profitability covers the capital expenditure costs of limited growth prospects for dividend paying firms, which decreases risk and return. Because constraints restrict external financing, firms with less exacting growth limits retain earnings rather than pay dividends to finance business investment. High profitability permits high growth which requires high capital expenditure costs which induces high risk. Consistent with this prediction, we find high returns for high profitability, high market/book, non-dividend paying “growth” stocks, which is a negative value premium.

Financial Distress and the Value Premium

The value premium is the empirical observation that low market/book “value” stocks have higher returns than high market/book “growth” stocks. In this paper, we report evidence that there is a value premium for firms in financial distress despite the anomalous observation that firms in financial distress have low returns and low values. We argue that profitability moderates distress-risk but increases growth-leverage and, thus, we test for a U-shaped relation between returns and profitability from these offsetting forces. We also find a hill-shaped relation between market/book and profitability. A U-shaped relation between returns and profitability and a hill-shaped relation between market/book and profitability generates a value premium for firms in financial distress. When market/book is low (high or low profitability), returns are high.

Dynamic Growth Equity Returns

Within book/market quintiles, expected return from constant growth equity valuation (static growth expected return, SGER) relates positively with realized returns. However, SGER overstates realized returns for growth stocks and understates realized returns for value stocks. We investigate whether reversion in ROE, which is a SGER input, reconciles these biases. We compare several ROE forecasts using both historical and analysts’ earnings estimates but SGER continues to overstate (understate) returns for growth (value) stocks. On the other hand, the regression of return on ROE for value versus growth stocks is a conditional reduced-form version of a dynamic equity valuation model that recognizes the value-premium. We call return forecasts from these regressions dynamic growth expected returns, DGER, which in large part eliminate the value-versus-growth bias.

Positive Mean Currency Returns

In this paper, we report evidence that mean currency returns are positive for both a domestic investor in a foreign currency and a foreign investor in a domestic currency. A shared currency gain creates a positive volatility factor for both. Volatility dominates other return determinants that have opposite impacts on an exchange rate and its inverse to produce positive average returns that we find to be over one per-cent per annum. Positive mean returns impact the global asset allocation of investors to accumulate to a large fraction of wealth creation over time. Currency returns are also large given the common a-priori expectation of investors that they average zero.

Business Profit and Consumer Price Sensitivity

In this paper, we investigate the relation between business profit and the demand price-elasticity of consumers. Business profit increases with a decrease in customer price-sensitivity only when the relation between a firm’s net operating margin (after fixed-costs) and its price-cost margin (before fixed-costs) exceeds unity. We find this result empirically for firms in five industries that we investigate. However, we also find that advertising increases customer price-sensitivity. Nonetheless, businesses advertise because the positive profit impact of higher unit sales offsets the negative profit impact of greater customer price-sensitivity to increase profit on net. We conclude that the increase in customer price-sensitivity from advertising is not purposeful and that businesses cannot manipulate consumer tastes for higher profit.