A Framework for Identifying Accounting Characteristics for Asset Pricing Models, with an Evaluation of Book-to-Price

Abstract

The paper presents a framework for identifying accounting numbers that indicate risk and expected return. The framework establishes conditions under which book-to-price (B/P), so prominent in asset pricing, indicates expected returns: B/P indicates expected returns if it forecasts future earnings growth and the risk that the growth will not be realized. However, that condition is satisfied only under specific accounting conditions — it depends on the accounting for book value and associated earnings. The empirical analysis confirms that the conditions are satisfied under GAAP accounting, and so identifies book-to-price (B/P) as a valid risk characteristic for asset pricing. However, the framework also points to earnings-to-price (E/P) as a risk characteristic. Indeed, E/P, rather than B/P, is the relevant characteristic when there is no expected earnings growth, but the weight shifts to B/P with growth. The framework also enables the separation of the expected return for operating risk from that due to financing risk. With this separation, the paper revisits the puzzling negative relation that has been observed between leverage and realized returns, a finding that has been attributed to failure to control for operating risk. We find a positive relation between leverage and returns when operating risk characteristics identified by our framework are recognized.