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

49 Pages Posted: 29 Feb 2012

See all articles by Stephen H. Penman

Stephen H. Penman

Columbia Business School - Department of Accounting

Francesco Reggiani

University of Zurich

Multiple version iconThere are 3 versions of this paper

Date Written: February 1, 2012

Abstract

Historical cost accounting deals with uncertainty by deferring the recognition of earnings until the uncertainty has largely been resolved. Such accounting affects both earnings and book value, and produces expected earnings growth deemed to be at risk. This paper shows that the earnings-to-price and book-to-price ratios that are the product of this accounting forecast both earnings growth and the risk to that growth. The paper also shows that the market pricing of earnings and book values in these ratios aligns with the risk imbedded in the accounting: the returns to buying stocks on the basis of their earnings yield and book-to-price are explained as a rational pricing of the risk of expected earnings growth not being realized. Accordingly, the paper provides a rationalization of the well-documented book-to-price effect in stock returns: book-to-price indicates the risk in buying earnings growth. However, growth identified by a high book-to-price as yielding a higher return in this paper 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” requires modification.

JEL Classification: M41

Suggested Citation

Penman, Stephen H. and Reggiani, Francesco, Returns to Buying Earnings and Book Value: Accounting for Growth and Risk (February 1, 2012). Available at SSRN: https://ssrn.com/abstract=1536043 or http://dx.doi.org/10.2139/ssrn.1536043

Stephen H. Penman (Contact Author)

Columbia Business School - Department of Accounting ( email )

3022 Broadway
New York, NY 10027
United States
212-854-9151 (Phone)
212-316-9219 (Fax)

Francesco Reggiani

University of Zurich ( email )

Rämistrasse 71
Zürich, CH-8006
Switzerland

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