Book-to-Market Components, Future Security Returns, and Errors in Expected Future Earnings

Abstract

This study investigates the differential relations between components of book-to-market ratios and future stock returns. The decomposition follows the Ryan (1995) and Beaver and Ryan (1998) fixed effects estimation approach to categorize the deviations between book value and market value. We focus on a persistent firm effect (bias component), a lag recognition component, and a residual component. We find that the inverse relation between book-to-market and future returns identified in previous literature can be attributed to both the lag and bias components, but the lag component is the dominant factor. Given that lag is constructed by regressing book-to-market ratios on lagged price changes, our results are consistent with the lag component capturing systematic stock price reversals. We further find that the components have unique relations with future earnings forecasts and forecast revisions pertaining to different forecast horizons. Our component-level analysis provides insight into this market anomaly and suggests that the ability of book-to-market to predict returns primarily derives from its tendency to reflect systematic errors in expected future earnings. If risk plays a role in the future return relation, it appears to be a secondary effect.

JEL Classification: G12, G14, M41