Conservatism Correction for the Market-to-Book Ratio and Tobin's q

54 Pages Posted: 6 Mar 2014

See all articles by Maureen F. McNichols

Maureen F. McNichols

Stanford University

Madhav V. Rajan

Booth School of Business, University of Chicago

Stefan J. Reichelstein

Stanford University - Stanford Graduate School of Business; CESifo (Center for Economic Studies and Ifo Institute)

Date Written: February 20, 2014

Abstract

We decompose the market-to-book ratio into two additive components: a conservatism correction factor and a future-to-book ratio. The conservatism correction factor exceeds the benchmark value of one whenever the accounting for past transactions has been subject to an (unconditional) conservatism bias. The observed history of a firm’s past investments allows us to calculate the magnitude of its conservatism correction factor, resulting in an average value that is about two-thirds of the overall market-to-book ratio. We demonstrate that our measure of Tobin’s q, obtained as the market-to-book ratio divided by the conservatism correction factor, has greater explanatory power in predicting future investments than the market-to-book ratio by itself. Our model analysis derives a number of structural properties of the conservatism correction factor, including its sensitivity to growth in past investments, the percentage of investments in intangibles, and the firm’s cost of capital. We provide empirical support for these hypothesized structural properties.

JEL Classification: M410, L250, G110

Suggested Citation

McNichols, Maureen F. and Rajan, Madhav V. and Reichelstein, Stefan J., Conservatism Correction for the Market-to-Book Ratio and Tobin's q (February 20, 2014). CESifo Working Paper Series No. 4626; Rock Center for Corporate Governance at Stanford University Working Paper No. 176. Available at SSRN: https://ssrn.com/abstract=2404863

Maureen F. McNichols

Stanford University ( email )

655 Knight Way
Stanford, CA 94305-5015
United States
650-723-0833 (Phone)
650-725-7979 (Fax)

Madhav V. Rajan

Booth School of Business, University of Chicago

1101 East 58th Street
Chicago, IL 60637-1561
United States

Stefan J. Reichelstein (Contact Author)

Stanford University - Stanford Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States
650-736-1129 (Phone)
650-725-7979 (Fax)

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

HOME PAGE: http://www.CESifo.de

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