Can Operating Leverage Be the Cause of the Value Premium?

40 Pages Posted: 24 Dec 2007

See all articles by Luis García-Feijóo

Luis García-Feijóo

Florida Atlantic University - Department of Finance

Randy D. Jorgensen

Creighton University

Date Written: November 1, 2007

Abstract

Recent theoretical models (e.g., Carlson, Fisher and Giammarino, 2004) predict an association between the book-to-market (BE/ME) ratio and operating leverage in the cross-section. Consistent with these models, we find a strong positive association between BE/ME and the degree of operating leverage (DOL), and between DOL and subsequent stock returns in the cross-section. Additionally, we also find a positive association between size (i.e., market equity) and the degree of financial leverage (DFL), and a positive association between BE/ME and DFL, controlling for size. Overall, our findings provide support for a risk-based explanation for the value premium that is consistent with existing theoretical models. The evolution of systematic risk associated with firm-level investment activity, rather than financial distress, seems to be the main determinant of the value premium.

Keywords: Expected returns, Book-to-market, Operating Leverage, Value premium, Anomalies

JEL Classification: G12

Suggested Citation

Garcia-Feijoo, Luis and Jorgensen, Randy D., Can Operating Leverage Be the Cause of the Value Premium? (November 1, 2007). Available at SSRN: https://ssrn.com/abstract=1077739 or http://dx.doi.org/10.2139/ssrn.1077739

Luis Garcia-Feijoo (Contact Author)

Florida Atlantic University - Department of Finance ( email )

777 Glades Rd
Boca Raton, FL 33431
United States
954-236-1239 (Phone)

Randy D. Jorgensen

Creighton University ( email )

2500 California Plaza
College of Business
Omaha, NE 68178
United States

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