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Journal ArticleDOI

A comparison of investors’ sentiments and risk premium effects on valuing shares

01 May 2016-Finance Research Letters (Elsevier)-Vol. 17, pp 1-6

AbstractThis paper investigates at what extent deviations between market share prices and their fundamental values can be explained by risk premium and/or investors’ sentiment effects. This is done based on recent panel data econometric techniques controlling for the effects of unobserved common factors on our estimation and inference procedures. To calculate the fundamental values of the shares, the paper relies on book value and yearly earnings forecasts of the listed companies, over the period 1987–2012. The results of the paper indicate that share price deviations from their fundamental values can be explained by both risk premium and sentiment effects. The latter lead to overvaluation of market share prices during normal market time times. In contrast, during periods of financial crises, share prices tend to reverse to their fundamental values. The unobserved common factors identified by fitting our model into the data do not add too much to the explanatory power of it, compared to the observed economic variables often used in the literature to capture the sentiment and/or risk premium effects.

Topics: Liquidity premium (63%), Risk premium (60%), Market share (56%), Share price (56%), Panel data (52%)

Summary (2 min read)

1 Introduction

  • Ohlson s model has the following attractive features.
  • Identifying these factors and measuring their explanatory power on share prices can indicate at what extent compared to the observed ones can explain cross-sectional and time-series, total variation of share prices from their fundamental values.
  • Section 2 presents the share price valuation model, while Section 3 the empirical methodology of the paper and it discuss the estimation results.

2 Share valuation

  • These earnings constitute the di¤erence between rm s i earnings Eit+ and its opportunity cost of capital.
  • As it stands, model (1) does not allow for risk premium and/or investors sentiment e¤ects.
  • These e¤ects can explain deviations between the fundamental values of share prices, P it, and their market values, denoted as Pit.
  • On the other hand, investors sentiment e¤ects will tend to overvalue price.
  • Pit during periods of optimism of the market.

3 Empirical analysis

  • To investigate the relative importance of risk premium and/or sentiment e¤ects in explaining deviations of share prices from their fundamental values, i.e., Pit P it, the authors consider the following panel data model: (3) Model (2) considers three di¤erent groups of variables in explaining Pit P it.
  • The rst contains variables zijt, re ecting J-di¤erent rm speci c e¤ects, like the size of a rm i (denoted as SIZE), its earning-price, and its book-to-market and dividend-price ratios, denoted respectively as E=P , B=M and D=P .
  • These variables can capture the Fama-French risk premium factors.
  • These variables are common, for all shares i.
  • Panel data methods enable us to estimate the time series observations of factors fmt from the residuals of model (2), obtained in a rst step, by exploiting the cross-section dimension of the data.

3.1 Data

  • The authors data is expressed in nominal values and have annual frequency.
  • The stock market annual return (MARKET ) is calculated based on the FTSE100 UK price index.
  • The sentiment variable SENT is the percentage change of sentiment index, denoted as SI.
  • Earnings forecasts are based on combined estimates of the analysts about a company s earnings per share that concerns the next scal year.
  • Finally, the results of the table indicate that there is a very small degree of correlation between the rm speci c and macroeconomic variables of the model, which means that these two di¤erent groups of variables may be thought of as independent sources of risks.

3.2 Estimates

  • To estimate model (2), the authors will employ the mean group panel data estimator (see Pesaran and Smith (1995)).
  • Estimates of model (2), with and without unobserved factors fmt, based on the above estimation procedure are presented in Table 2.
  • Regarding the group of macroeconomic variables, their results indicate that TERM , EXCH and DF have a signi cant impact on Pit P it, at the 5% level, for all the speci - cations of the model considered.
  • They indicate that the e¤ects of investors sentiments on Pit P it become stronger than those based on the mean group estimator.
  • This is also true for the speci cation of the model including variable CRISIS into its RHS.

4 Conclusions

  • Based on a share valuation model which relies on analysts earnings forecasts and book values, this paper shows that deviations of the market share prices from their fundamental values can be explained both by risk premium an/or investors sentiment e¤ects.
  • The paper provides clear cut evidence that positive sentiment e¤ects (due, for instance, to investors optimism) lead to overvaluation of the current market share prices, compared to their fundamental values.
  • On the other hand, sentiment e¤ects occurring in periods of nancial crisis, often associated with collapsing bubbles, lead to share price corrections to their fundamental values.
  • Regarding the risk premium e¤ects, the results of the paper show that these can be captured by rm speci c variables, like the book-to-market and dividend-price ratios, and macroeconomic variables, like the spread between long and short term government yields, the change of the three month T-bill rate and the e¤ective real exchange rate.

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University of Birmingham
A comparison of investors’' sentiments and risk
premium effects on valuing shares
Karavias, Yiannis; Spilioti, Stella; Tzavalis, Elias
DOI:
10.1016/j.frl.2015.10.017
License:
Creative Commons: Attribution-NonCommercial-NoDerivs (CC BY-NC-ND)
Document Version
Peer reviewed version
Citation for published version (Harvard):
Karavias, Y, Spilioti, S & Tzavalis, E 2015, 'A comparison of investors’' sentiments and risk premium effects on
valuing shares', Finance Research Letters. https://doi.org/10.1016/j.frl.2015.10.017
Link to publication on Research at Birmingham portal
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Download date: 10. Aug. 2022

A comparison of investorssentiments and risk
premium e¤ects on valuing shares
Yiannis Karavias
a;
, Stella Spilioti
b
and Elias Tzavalis
b
September 15, 2015
Abstract
This paper investigates at what extent deviations between market share prices and
their fundamental values can be explained by risk premium and/or investors’sentiment
ects. This is done based on recent panel data econometric techniques controlling for
the ects of unobserved common factors on our estimation and inference procedures.
To calculate the fundamental values of the shares, the paper relies on book value
and yearly earnings forecasts of the listed companies, over period 1987-2012. The
results of the paper indicate that share price deviations from their fundamental values
can be explained by both risk premium and sentiment ects. The latter lead to
overvaluation of market share prices during normal market time times. In contrast,
during periods of nancial crises, share prices tend to reverse to their fundamental
values. The unobserved common factors identi…ed by tting our model into the data do
not add too much to the explanatory power of it, compared to the obse rved economic
variables often used in the literature to capture the sentiment and/or risk p remium
ects.
JEL classi…cation: G12, G14, G15
Keywords: share prices, risk premium, sentiments, panel data, rm speci…c ects.
The authors would like to thank the editor Douglas Cumming and an anonymous
referee for very constructive comments on the previous version of the paper.
*: Corresponding author. a: University of Birmingham, b: Athens University
of Economics and Business. Yiannis Karavias, Department of Economics, University
of Birmingham, i.karavias@bham.ac.uk. Tzavalis Elias, Department of Economics,
Athens University of Economics & Business, E.Tzavalis@aueb.gr. Spilioti Stella, De-
partment of Business Administration, Athens University of Economics & Business,
Spilioti@aueb.gr
1

1 Introduction
Based on Ohlson’s (1995) share price valuation model, this paper examines if deviations
of share prices from their fundamental values can be explained by missing risk premium
ects (see, Fama and French (1993,2014)) and/or investors’behavioral biases (e.g., excessive
optimism or other psychological characteristics referred to as investors’sentiments, see De
Bondt and Thaler (1987), Barberis et al (1998), and Baker and Wurgler (2006)). Ohlsons
model has the following attractive features. It treats investment in a share as a balance sheet
factor, and not as one that reduces cash ows (see Penman and Sougiannis (1998)). It relies
its valuation on the book value of a rm, which is a readily available variable, and on the
present value of future abnormal earnings for some years ahead, which can be obtained from
nancial statement data announced by rms. Thus, it avoids making assumptions about
future dividends processes.
Our empirical methodology employs recently developed panel data econometric tech-
niques controlling for the ects of unobserved common factors on the explanatory power
of regressors capturing risk premium and/or sentiment ects. Identifying these factors and
measuring their explanatory power on share prices can indicate at what extent compared to
the observed ones can explain cross-sectional and time-series, total variation of share prices
from their fundamental values. The data used in our analysis includes 37 companies from
the FTSE 100 index, traded continuously in the UK stock market between years 1987 and
2012. This period covers a number of extraordinary events, like the years 1987, 1997, 2001,
2008 and 2010 stock markets crises, which may have triggered behavioral ects on share
prices.
The paper is organized as follows. Section 2 presents the share price valuation model,
while Section 3 the empirical methodology of the paper and it discuss the estimation results.
Section 4 concludes the paper.
2

2 Share valuation
Ohlson’s model (see also Feltham and Ohlson (1995)) suggests that the fundamental (the-
oretical) value of share i, at time t (denoted P
it
), is determined by the book value and
discounted future abnormal earnings, i.e.,
P
it
= B
it
+
X
n
=1
E
t
(E
it+
r
f
B
it+1
)
(1 + r
f
)
; for all i; (1)
where B
it+1
and E
it+
respectively denote the book value and company (…rm) earnings
per share, r
f
is the risk-free interest rate (known as discount factor), E
t
(.) denotes the
expectations’ operator conditional on the current t-time information set I
t
and E
it+
r
f
B
it+1
presents the abnormal earnings of rm i in future period t + . These earnings
constitute the di¤erence between rm’s i earnings E
it+
and its opportunity cost of capital.
As competition forces, earnings E
it+
r
f
B
it+1
are assumed to converge to zero. Thus,
they are set to zero in (1), after period t + n.
As it stands, model (1) does not allow for risk premium and/or investors’ sentiment
ects. These ects can explain deviations between the fundamental values of share prices,
P
it
, and their market values, denoted as P
it
. Risk premium ects are expected to reduce
the actual (market) share price P
it
, at time t, compared to its fundamental value P
it
in order
to discount for possible future loses, or reductions, in future earnings E
it+
r
f
B
it+1
.
Such loses will require higher expected returns on a share i, compared to that implied by its
fundamental value P
it
. On the other hand, investors’sentiment ects will tend to overvalue
price P
it
during periods of optimism of the market. In contrast, in periods of nancial crises
(often associated with bubbles burst), sentiment ects will have reverse ects on P
it
(see,
Brown and Cli¤ (2004), Shan and Gong (2012), and Smales (2014)). These will tend to
revert P
it
towards its fundamental value P
it
.
3 Empirical analysis
To investigate the relative importance of risk premium and/or sentiment ects in explaining
deviations of share prices from their fundamental values, i.e., P
it
P
it
, we consider the
3

following panel data model:
P
it
P
it
= c
i
+
J
X
j=1
ij
z
ijt
+
K
X
k=1
ik
x
kt
+
i
SENT
t
+u
it
, for i = 1; 2; :::; N and t = 1; 2; :::; T ,
(2)
where u
it
stands for the error term which has a common factor representation, i.e.,
u
it
=
M
X
m=1
a
im
f
mt
+ e
it
; with e
it
IID(0;
2
e
). (3)
Model (2) considers three di¤erent groups of variables in explaining P
it
P
it
. The rst
contains variables z
ijt
, reecting J-derent rm speci…c ects, like the size of a rm i
(denoted as SIZE), its earning-price, and its book-to-market and dividend-price ratios,
denoted respectively as E=P , B=M and D=P . These variables can capture the Fama-French
risk premium factors. The second group, de…ned by variables x
kt
, includes K-observed
macroeconomic variables re‡ecting business cycle movements of the risk premium (see Ferson
and Harvey (1993) and Flannery and Protopapadakis (2002)). These variables are common,
for all shares i. They often include the GDP growth rate (GROW T H), in‡ation rate (INF ),
the term spread between the long and short term interest rates (T ERM), the discount
interest rate factor (DF ) and the real ective exchange rate (EXCH), as well as the stock
market aggregate return (MARKET ), used by the CAPM to price the market risk premium
ects. Finally, the last group of explanatory variables contains those capturing investors’
sentiment ects (denoted as SENT ).
One attractive feature of model (2) is that, apart from observed economic variables, it
allows for M-unobserved common factors f
mt
to explain price deviations P
it
P
it
. Estimating
the model with these factors can evaluate if there are any remaining factors with signi…cant
explanatory power on P
it
P
it
, beyond those captured by the observed economic variables
considered above. The relative importance of these factors on P
it
P
it
can be assessed by
a t performance measure of the model, like the co cient of determination R
2
and/or an
information criterion. Panel data methods enable us to estimate the time series observations
of factors f
mt
from the residuals of model (2), obtained in a rst step, by exploiting the
cross-section dimension of the data.
4

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This paper investigates at what extent deviations between market share prices and their fundamental values can be explained by risk premium and/or investors’sentiment e¤ects. To calculate the fundamental values of the shares, the paper relies on book value and yearly earnings forecasts of the listed companies, over period 1987-2012. The results of the paper indicate that share price deviations from their fundamental values can be explained by both risk premium and sentiment e¤ects. The authors would like to thank the editor Douglas Cumming and an anonymous referee for very constructive comments on the previous version of the paper.