Earnings, Retained Earnings, and Book-to-Market in the Cross Section of Expected Returns
54 Pages Posted: 1 Mar 2017 Last revised: 25 Sep 2017
Date Written: September 25, 2017
We delve into what causes the relation between book-to-market and the cross section of stock returns. Book value of equity consists of two main components that we expect contain different information about expected returns: retained earnings and contributed capital. Retained earnings-to-market subsumes book-to-market's power to predict the cross section of stock returns in pre- and post-Compustat U.S. data as well as in international data. Contributed capital-to-market has no predictive power. Retained earnings represent the accumulated difference between earnings and dividends. We show that retained earnings-to-market's predictive power stems entirely from accumulated earnings. Our thesis is that retained earnings-to-market---and, by extension, book-to-market---predicts returns because it is a good proxy for earnings yield (Ball,1978; Berk, 1995).
Keywords: G11, G12, M41
JEL Classification: Book-to-market, Contributed capital, Earnings yield, Mispricing, Retained earnings, Value premium
Suggested Citation: Suggested Citation