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

56 Pages Posted: 25 Aug 2011

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: May 1, 2010

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.

Suggested Citation

Penman, Stephen H. and Reggiani, Francesco, Returns to Buying Earnings and Book Value: Accounting for Growth and Risk (May 1, 2010). Columbia Business School Research Paper . Available at SSRN: https://ssrn.com/abstract=1916318

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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