Abstract

http://ssrn.com/abstract=1536618
 
 

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Returns to Buying Earnings and Book Value: Accounting for Growth and Risk


Francesco Reggiani


Bocconi University - Department of Accounting

Stephen H. Penman


Columbia University - Department of Accounting

December 1, 2009


Abstract:     
This paper documents that the earnings yield and book-to-price combine to predict equity returns in a way that is consistent with the rational pricing of risk. It is well known that earnings yields predict returns in the cross-section, consistent with standard formulas that show that the earnings yield equals the required return when there is no expected earnings growth beyond that from retention. With growth, those same formulas show that the earnings yield is increasing in the required return but decreasing in the growth. So, if growth is risky and requires a higher return, the determination of the required return from a given earnings yield is problematical. The paper shows that book-to-price facilitates the determination: for a given earnings yield, book-to-price indicates additional return associated with expected growth. The finding provides a rationalization of the well-documented book-to-price effect in stock returns: book-to-price indicates the risk in buying earnings and earnings growth. However, growth identified by a high book-to-price as yielding a higher return is quite different from “growth” typically attributed to a low book-to-price as yielding a lower return. Accordingly, the notion of “growth” versus “value” is redefined.

Number of Pages in PDF File: 55

JEL Classification: G12, G32

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Date posted: February 9, 2010 ; Last revised: August 17, 2011

Suggested Citation

Reggiani, Francesco and Penman, Stephen H., Returns to Buying Earnings and Book Value: Accounting for Growth and Risk (December 1, 2009). Available at SSRN: http://ssrn.com/abstract=1536618 or http://dx.doi.org/10.2139/ssrn.1536618

Contact Information

Francesco Reggiani
Bocconi University - Department of Accounting ( email )
Via Roentgen 1
Milan, 20136
Italy
Stephen H. Penman (Contact Author)
Columbia University - Department of Accounting ( email )
3022 Broadway
New York, NY 10027
United States
212-854-9151 (Phone)
212-316-9219 (Fax)

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