In this study, we propose a modified residual income model that incorporates Tobin’s Q as a proxy for growth. Empirical results show that the proposed model outperforms other alternative models in predicting a firm’s value. By assuming that stocks are mispriced if they deviate from the estimated intrinsic values, we can then develop an arbitrage strategy that sells the overvalued stocks and buys the undervalued stocks. The arbitrage strategy based on the proposed model also outperforms the Ohlson’s residual income model (1995), the Campbell-Shiller’s valuation model (1995), and other contrarian strategies based on various accounting-fundamental-to-price ratios. We further trace the source of mispricing and conclude that, by controlling the growth variables, it can be attributed to a simple truth that investors are unable to distinguish discretionary accruals from reported earnings.

Abarbanell, J.S. and Bushee, B.J., 1997, “Fundamental Analysis, Future Earnings, and Stock Prices”, Journal of Accounting Research, 35 (1), 1-24.
Abarbanell, J.S. and Bushee, B.J., 1998, “Abnormal Returns to a Fundamental Analysis Strategy”, The Accounting Review, 73 (1), 19-45.
Ali, A., Chen, X., Yao, T., and Yu, T., 2008, “Do Mutual Funds Profit from the Accruals Anomaly?”, Journal of Accounting Research, 46 (1), 1-26.
Ali, A., Hwang, L.S., and Trombley, M.A., 2003, “Residual-Income-Based Valuation Predicts Future Stock Returns: Evidence on Mispricing vs. Risk Explanations”, The Accounting Review, 78 (2), 377-396.
Altman, E.I., 1968, “Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy”, The Journal of Finance, 23, 589-609.
Bagella, M., Becchetti, L. and Adriani, F., 2003, “Observed and “Fundamental” Price Earning Ratios: a Comparative Analysis of High-Tech Stock Evaluation in the US and in Europe”, working paper.
Ball, R. and Brown, P., 1968, “An Empirical Evaluation of Accounting Income Numbers”, Journal of Accounting Research, 6, 159-178.
Battalio, R.H. and Mendenhall, R.R., 2006, “Post-Earnings Announcement Drift: Timing and Liquidity Costs”, working paper.
Barth, M., Clement, M., Foster, G. and Kasznik, R., 1998, “Brand Values and Capital Market Valuation”, Review of Accounting Studies, 3, 41-68.
Bartov, E., Gul, F.A., and Tsui, J.S.L., 2001, “Discretionary-accruals Models and Audit Qualifications”, Journal of Accounting and Economics, 30, 421-452.
Basu, S., 1977, “Investment Performance of Common Stocks in Relation to Their Price Earnings Ratios: A Test of the Efficient Market Hypothesis”, Journal of Finance, 32, 663-682.
Basu, S., 1983, “The Relationship between Earnings Yield, Market Value and Return for NYSE Stocks: Further Evidence”, Journal of Financial Economics, 12, 779-793.
Basu, S., 2002, “The Relationship between Earnings' Yield, Market Value and Return for NYSE Common Stocks Further Evidence”, Journal of Financial Economics, 12,129-156.
Beaver, W., 2002, “Perspectives on Recent Capital Market Research”, The Accounting Review, 77 (2), 453-474.
Beneish, M.D., Lee, C.M.C., and Tarpley, R.L., 2001, “Contextual Fundamental Analysis through the Prediction of Extreme Returns”, Review of Accounting Studies, 6, 165-189.
Bernard, V.L., 1995, “The Feltham-Ohlson Framework: Implication for Empiricists”, Contemporary Accounting Research, 11, 733-747.
Bierman, Jr.H., 2002, “The Price-Earnings Ratio”, Journal of Portfolio Management, 28, 57-60.
Campbell, J.Y. and Shiller, R.J., 1988, “The Dividend–Price Ratio and Expectations of Future Dividends and Discount Factors”, Review of Financial Studies, 1, 195–228.
Chan, L., Hamao, Y., and Lakonishok, J., 1991, “Fundamentals and Stock Returns in Japan”, Journal of Finance, 46, 1739-1764.
Chen, C.R., Lung, P.P., and Wang, F.A., 2009, “Mispricing and the Cross-Section of Stock Returns”, Review of Quantitative Finance and Accounting, 32 (4), 317-349.
Cheng, C.S.A. and Thomas, W.B., 2006, “Evidence of the Abnormal Accrual Anomaly Incremental to Operating Cash Flows”, The Accounting Review, 81 (5), 1151-1167.
Chung, K.H. and Pruitt, S.W., 1994, “A Simple Approximation of Tobin’s Q”, Financial Management, 23, 70-74.
Collins, D.W., Gong, G., and Hribar, P., 2003, “Investor Sophistication and the Mispricing of Accruals”, Review of Accounting Studies, 8, 251-276.
Collins, D.W., Maydew, E.L., and Weiss, I.S., 1997, “Changes in the Value-Relevance of Earnings and Book Values over the Past Forty Years”, Journal of Accounting and Economics, 24, 39-67.
Core, J.E., 2006, “Discussion of an Analysis of the Theories and Explanations Offered for the Mispricing of Accruals and Accrual Components”, Journal of Accounting Research, 44 (2), 341-350.
Core, J.E., Guay, W.R., and Buskirk, A.V., 2003, “Market Valuations in the New Economy: An Investigation of What Has Changed”, Journal of Accounting and Economics, 34, 43-67.
Davidson, R., and MacKinnon, J., 1981, “Several Tests for Model Specification in the Presence of Alternative Hypotheses”, Econometrica, May, 781-793.
Dechow, P.M., Sloan, R.G., Sweeney, A.P., 1995, “Detecting Earnings Management”, The Accounting Review, 70, 193-225.
Dechow, P.M. and Sloan, R.G., 1997, “Returns to Contrarian Investment Strategies: Tests of Naïve Expectations Hypotheses”, Journal of Financial Economics, 43, 3-27.
Dechow, P.M., Hutton, A.P., and Sloan, R.G., 1999, “An Empirical Assessment of the Residual Income Valuation Model”, Journal of Accounting and Economics, 26, 1-34.
Desai, H., Rajgopal, S., and Venkatachalam, M., 2004, “Value-Glamour and Accruals Mispricing: One Anomaly or Two?”, The Accounting Review, 79 (2), 355-385.
Easton, P.D. and Harris, T.S., 1991, “Earnings as an Explanatory Variables for Returns”, Journal of Accounting Research, 29, 19-36.
Estrada, J., 2005, “Adjusting P/E Ratios by Growth and Risk: the PERG Ratio”, International Journal of Managerial Finance, 1, 187-203.
Evans, J.L. and Archer, S.H., 1968, “Diversification and the Reduction of Dispersion: An Empirical Analysis”, The Journal of Finance, 23, 761-767.
Fama, E.F. and French, K.R., 1992, “The Cross-Section of Expected Stock Returns”, Journal of Finance, 47, 427–465.
Fama, E.F. and French, K.R., 1993, “Common Risk Factors in the Returns on Stocks and Bonds,” Journal of Financial Economics, 33, 3-56.
Fama, E.F. and French, K.R., 1995, “Size and Book-to-Market Factors in Earnings and Returns,” The Journal of Finance, 50, 131-155.
Feltham, G.A. and Ohlson, J.A., 1995, “Valuation and Clean Surplus Accounting for Operating and Financial Activities”, Contemporary Accounting Research, 11, 689-731.
Feltham, G.A. and Ohlson, J.A., 1996, “Uncertainty Resolution and Theory of Depreciation Measurement”, Journal of Accounting Research, 34, 209-234.
Francis, J., Olsson, P., and Oswald, D., 2000, “Comparing the Accuracy and Explainability of Dividend, Free Cash Flow and Abnormal Earnings Equity Valuation Estimates”, Journal of Accounting Research, 38(1), 45-70.
Frankel, R. and Lee, C.M.C., 1998, “Accounting Valuation, Market Expectation, and Cross-Sectional Stock Returns”, Journal of Accounting and Economics, 25, 283-320.
Gabrielsen, G., Gramlich, J., and Plenborg, T., 2002, “Managerial Ownership, Information Content of Earnings, and Discretionary Accruals in a Non-US Setting”, Journal of Business, Finance and Accounting, 29, 967-988.
Hayn, C., 1995, “The Information Content of Losses”, Journal of Accounting and Economics, 20, 125-153.
Healy, P.M., 1985, “The Effect of Bonus Schemes on Accounting Decisions”, Journal of Accounting and Economics, 7, 85-107.
Hilary, G. and Menzly, L., 2006, “Does Past Success Lead Analysts to Become Overconfident?”, Management Science, 52 (4), 489-500.
Jahnke, G., 1987, “Price Earnings Ratio and Security Performance”, Journal of Portfolio Management, 14, 39-46.
Jegadeesh, N. and Titman, S., 1993, “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency”, Journal of Finance, 48, 65-91.
Jensen, M., 1968, “The Performance of Mutual Funds in the Period 1945-1964”, The Journal of Finance, 23 (2), 389-416.
Jones, J., 1991, “Earnings Management During Import Relief Investigations”, Journal of Accounting Research, 29 (Autumn), 193-228.
Joos, P. and Plesko, G.A., 2005, “Valuing Loss Firms”, The Accounting Review, 80, 847-870.
Kester, W.C., 1984, “Today’s option for tomorrow’s growth”, Havard Business Review, 153-160.
Khan, M., 2008, “Are Accruals Mispriced? Evidence from Tests of An Intertemporal Capital Asset Pricing Model”, Journal of Accounting and Economics, 45, 55-77.
Kraft, A., Leone, A., and Wasley, C., 2006, “An Analysis of the Theories and Explanations Offered for the Mispricing of Accruals and Accrual Components”, Journal of Accounting Research, 44 (2), 297-339.
Lakonishok, J., Shleifer, A., and Vishny, R.W., 1994, “Contrarian Investment, Extrapolation, and Risk”, Journal of Finance, 49, 1541–1578.
Lee, C.M.C., Myers, J., and Swaminathan, B., 1999, “What is the Intrinsic Value of the Dow?”, The Journal of Finance, 54 (5), 1693-1741.
Lev, B. and Nissim, D., 2006, “The Persistence of the Accruals Anomaly”, Contemporary Accounting Research, 23 (1), 193-226.
Lev, B. and Thiagarajan, S.R., 1993, “Fundamental Information Analysis”, Journal of Accounting Research, 31 (2), 190-215.
Mashruwala, C., Rajgopal, S., and Shevlin, T., 2006, “Why is the Accrual Anomaly not Arbitraged Away? The Role of Idiosyncratic Risk and Transaction Costs”, Journal of Accounting and Economics, 42, 3-33.
Nicholson, F., 1960, “Price-Earnings Ratios”, Financial Analysts’ Journal, 16, 43–45.
Ohlson, J.A., 1995, “Earnings, Book Value and Dividends in Equity Valuation”, Contemporary Accounting Research, 11, 661-667.
Ohlson, J.A. and Zhang, X.J., 1998, “Accrual Accounting and Equity Valuation”, Journal of Accounting Research, 36, 85-111.
Ohlson, J.A., 2001, “Earnings, Book Value and Dividends in Equity Valuation: An Empirical Perspective”, Contemporary Accounting Research, 18 (1), 107-120.
Ou, J.A. and Penman, S.H., 1989, “Financial Statement Analysis and the Prediction of Stock Returns”, Journal of Accounting and Economics, 11, 295-329.
Penman, S.H., and Sougiannis, T., 1998, “A Comparison of Dividend, Cash Flow, and Earnings Approaches to Equity Valuation”, Contemporary Accounting Research, 15, 343-383.
Reinganum, M.R., 1981, “Misspecification of Capital Asset Pricing-Empirical Anomalies Based on Earnings’ Yields and Market Values”, Journal of Financial Economics, 9, 19-46.
Riahi-Belkaoui, A. and Picur, R., 2001, “Investment Opportunity Set Dependence of Dividend Yield and Price Earnings Ratio”, Managerial Finance, 27(3), 65-71.
Sharpe, W.F., 1966, “Mutual Fund Performance”, Journal of Business (January), 119-138.
Shawky, H.A. and Smith, D.M., 2005, “Optimal Number of Stock Holdings in Mutual Fund Portfolios Based on Market Performance”, The Financial Review, 40, 481-495.
Sloan, R., 1996, “Do Stock Prices Fully Impound Information in Accruals about Future Earnings?”, The Accounting Review, 71 (July), 289-315.
Statman, M., 1987, “How Many Stocks Make a Diversified Portfolio?”, Journal of Financial and Quantitative Analysis, 22, 353-363.
Treynor, J.L., 1965, “How to Rate Management of Investment Funds”, Harvard Business Review, 43 (1), 63-75.
Warfield, T., Wild, J., and Wild, K., 1995, “Managerial Ownership, Accounting Choices and Informativeness of Earnings”, Journal of Accounting and Economics, 20, 61-91.
Xie, H., 2001, “The Mispricing of Abnormal Accruals”, The Accounting Review, 76 (3), 357-373.
Zhang, X.J., 2000, “Conservative Accounting and Equity Valuation”, Journal of Accounting and Economics, 29, 125-149.