Including Cash Flow Risk In Stock Return Analysis

Abstract

Despite their prominence in financial theory and practice, the Capital Asset Pricing Model and its critical beta component have failed test after test to explain stock returns.  Research by Campbell and Vuolteenaho cites the misspecification of beta as the reason for this failure.  They measure beta as the sum of two components: a more influential “cash-flow” beta and a secondary “discount-rate” beta.  The current study creates a ratio between the overall beta of a stock and the cash-flow component and uses an ordinary least squares regression model to determine its significance in interpreting overall returns to a stock, hypothesizing that the ratio will better explain returns than the overall beta alone.  The results are mixed but suggest significant explanatory power for the beta range of 0.60 to 0.95.