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

55 Pages Posted: 9 Feb 2010 Last revised: 17 Aug 2011

Francesco Reggiani

University of Zurich

Stephen H. Penman

Columbia Business School - Department of Accounting

Multiple version iconThere are 3 versions of this paper

Date Written: 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.

JEL Classification: G12, G32

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: https://ssrn.com/abstract=1536618 or http://dx.doi.org/10.2139/ssrn.1536618

Francesco Reggiani

University of Zurich ( email )

Rämistrasse 71
Zürich, CH-8006
Switzerland

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)

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