Forecasting Cross-section Stock Returns using the Present Value Model

We contribute to the debate over whether forecastable stock returns reflect an
unexploited profit opportunity or rationally reflect risk differentials. We test whether
agents could earn excess returns by selecting stocks which have a low market price
compared to an estimate of the fundamental value obtained from the present value
model. The criterion for stock picking is one which could actually have been
implemented by agents in real time. We show that statistically significant, and
quantitatively substantial, excess returns are delivered by portfolios of stocks which
are cheap relative to our estimate of fundamental value. There is no evidence that the
under priced stocks are relatively risky and hence excess returns cannot easily be
interpreted as an equilibrium compensation for risk.