A Factor Model of Company Relative Valuation

This paper applies the classic arbitrage pricing theory to an expected return transformation of company value and builds a factor model of company relative valuation. The model explains the cross-sectional variation of company value relative to book capital with a set of valuation factors constructed on a long list of firm characteristic features. A cross-sectional contemporaneous regression identifies the common market pricing of each valuation factor in its contribution to company valuation. The pricing residual captures company misvaluation. A statistical arbitrage portfolio targeting the pricing residual generates highly positive returns with low risk. The market pricing estimate predicts the future return on the corresponding factor portfolio and can be applied to factor timing.