Value or Growth? Pricing of Idiosyncratic Cash Flow Risk with Heterogeneous Beliefs

Abstract

We study an equilibrium continuous-time exchange economy where idiosyncratic cash flow risks are priced via investors' heterogeneous beliefs. Investors perceive idiosyncratic cash flow risks differently through heterogeneous subjective mean growth rates on a firm's cash flows. This impacts equilibrium quantities. Our model shows that idiosyncratic cash flow shocks priced through belief differences can explain cross-sectional variation in stock returns and cash flows. Quantitative results show that a value premium arises, as value stocks have higher idiosyncratic cash-flow volatilities, lower average cash flows, and higher belief differences, which is empirically supported. A growth premium prevails without belief differences.