NCPA - National Center for Policy Analysis


December 2, 2005

Researchers examined whether stocks' bad and good betas (or the sensitivity of the stock's return on the market as a whole), are determined by the characteristics of their cash flows -- the fundamentals view -- or whether they arise from the discount rates, possibly driven by sentiment, that investors apply to those cash flows.

The researchers subject both the fundamentals view and the sentiment view to a number of tests. Their results, they say, have important implications for understanding the underlying cash-flow risks of value and growth companies, strongly suggesting there is more to growth than mere "glamour."

  • The data indicate that the bad beta of value stocks and the good beta of growth stocks are both primarily determined by the cash-flow news of those stocks.
  • The researchers found that the profitability of value stocks is more sensitive to the market's profitability but less sensitive to the market's price-earnings ratio than is the profitability of growth stocks.
  • They also found that a firm's book-market ratio predicts its bad beta positively and its good beta negatively, consistent with the findings of earlier studies.

But when they deconstruct each firm's bad and good beta into components driven by the firm's cash-flow news and discount rate news, they find that the book-market ratio primarily predicts the cash-flow component of the bad beta, not the discount-rate component.

All these test results point in the same direction: The high betas of growth stocks with the market's discount-rate shocks, as well as the high betas of value stocks with the market's cash-flow shocks, turn out to be determined by the cash-flow fundamentals of both growth and value companies.

Source: Matt Nesvisky, "Fundamentals and Systematic Risk in Stock Returns," NBER Digest, November 2005; based upon: John Campbell, Christopher Polk and Tuomo Vuolteenaho, "Growth or Glamour? Fundamentals and Systematic Risk in Stock Returns," National Bureau of Economic Research, Working Paper No. 11389, June 2005.

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