Fundamentals-based risk measurement in valuation

We propose a methodology to incorporate risk measures based on economic fundamentals directly into the valuation model. Fundamentals-based risk adjustment in the residual income valuation model is captured by the covariance of ROE with market-wide factors. We demonstrate a method of estimating covariance risk out of sample based on the accounting beta and betas of size and book-to-market factors in earnings. We show how the covariance risk estimate can be transformed to obtain the fundamentals-based cost of equity. Our empirical analysis shows that value estimates based on fundamental risk adjustment produce significantly smaller deviations from price relative to the CAPM or the Fama-French three-factor model. We further find that our single-factor risk measure, based on the accounting beta alone, captures aspects of risk that are indicated by the book-to-market factor, largely accounting for the "mispricing" of value and growth stocks. Our study highlights the usefulness of accounting numbers in pricing risk beyond their role as trackers of returns-based measures of risk.