DeGroote School of Business

Determinants and Predictability of Commodity Producer Returns

Author(s): Qiao Wang and Ronald Balvers
Web Index: 2021-03
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Abstract

We derive stock returns for firms producing nonrenewable commodities employing the investment-based asset pricing approach. By identifying the appropriate time-varying discount rate the investment-based approach allows an alternative test of the Hotelling Valuation Principle. The empirical results support the principle and enable predicting returns from sorting firms into quintiles by expected return, producing a 16-20 percent realized difference between top and bottom quintile. The return differences cannot be explained by standard risk factors or a commodity-specific factor, suggesting that an important risk factor is still missing from standard models. The approach permits cost-of-capital estimation that circumvents identifying systematic risk factors.

Valuation Insight

The paper provides specific factors that determine the cost of capital of commodity-producing firms through the production-based asset pricing approach. This cost of capital measure may be applied to the discounted cashflows for valuation purposes, without risk factors needing to be specified.

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