Streamlining Fundamental Models

Streamlining Fundamental Models


When a scholar is also one of the most indisputable experts of a field, he or she reaches a stage in which challenging theories that shaped the literature becomes approachable. This is what Stephen Penman, Distinguished Professor at Bocconi Department of Accounting, does in his most recent publication in the Journal of Accounting and Economics. Specifically, the article aims to recast the well-known consumption-based price model but from an accounting outcome perspective.
The consumption-based price model is part of wide stream of literature which crosses several fields and has its roots in the capital asset pricing model (also known with the acronym CAPM). CAPM describes the relationship between the risk embedded in the market and the expected return of assets. The result of this model is represented by a factor – also known as beta – that tells how much risk an investor is adding to his or her portfolio by investing in that specific stock. The higher the added risk, the higher the return an investor expects (requires) from an asset.
When the beta employed represents not the systemic risk, but the added uncertainty in consumption growth that would come to an investor from holding the asset, we have the consumption-based model. The higher the added uncertainty in consumption growth, the higher the return an investor expects (requires) from an asset.
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Even if many scholars have attempted to provide new empirical evidence to the model, Professor Penman, together with his co-author Julie Zhu (Fudan University), brings to the table of asset pricing literature a model that uses accounting principles as bridge between consumption and key accounting variables.
The two accounting relations adopted by Penman are the “clean-surplus” and the “realization principle for booking earnings”. While the first has the objective of explaining the existing relationship between asset book value, earnings, and dividends, the second explicates that earnings are booked only when the risk is resolved.
The key novelties presented by the model are the presence of a single factor and its interpretability. As a matter of fact, the model is defined by its authors as “parsimonious” because it captures most of the returns by adopting one single factor. This represents a point of distance from those models that use a “zoo of factors”.
Moreover, the factor is transparent because its interpretation is straight forward. This is easily traceable back to the philosophy of Professor Penman of working with concrete tools.
Interestingly, thanks to their new research, Penman and Zhu brought to light that accounting numbers have their relevance. Indeed, they are able to tell their own story and should not be ignored by scholars as well as practitioners because they convey useful information about risk and expected returns.
Penman, S., & Zhu, J. (2022). “An accounting-based asset pricing model and a fundamental factor.” Journal of Accounting and Economics, 101476. DOI:

by Giulia Sargiacomo
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