An optimized DEA-based financial strength indicator of stock returns for U.S. markets

This chapter presents a data envelopment analysis (DEA) based relative financial strength (RFS) indicator using accounting data that is predictive of stock market performance of public firms. Such an indicator is indispensable in the fundamental analysis of firms for stock portfolio selections. This methodology requires optimally configuring inputs and outputs for the DEA model such that the strength indicator is maximally correlated with observed stock returns. This optimized RFS indicator providing the maximum predictive strength of stock returns is determined by factors such as asset utilization, leverage, profitability, and growth rates, in addition to the well-known factor, book-to-market ratio. Computational evidence is provided using more than 800 firms covering all major sectors of the U.S. stock market. Using quarterly financial data, we employ the RFS indicator to devise portfolios that yield superior financial performance relative to using portfolios of sector-based funds.