A two-dimensional innovation activity factor and stock pricing: Evidence from the Chinese stock market

This paper confirms that innovation activities can bring about excess stock returns in the Chinese stock market. Using monthly data on A-share stocks from May 2007 to December 2022, we find a significant innovation premium in the Chinese stock market by constructing a composite indicator that includes both innovation input and output. Then, we propose a six-factor model by incorporating the innovation factor into the Fama-French five-factor model. Time-series regressions show that the proposed model works well in explaining the variation of excess stock returns, and the innovation factor makes a significant marginal contribution to the explanatory power. Further tests show that the results remain robust for value-weighted returns, individual stocks, and different boards. The proposed model effectively reduces the root mean square errors compared to traditional pricing models. Our study adds significant evidence verifying the value of innovation in financial markets, and also provides practical implication for better enterprise innovation managment and public services.