Earnings, Retained Earnings, and Book-to-Market in the Cross Section of Expected Returns

44 Pages Posted: 1 Mar 2017 Last revised: 8 Mar 2017

Ray Ball

University of Chicago - Accounting

Joseph J. Gerakos

Tuck School of Business at Dartmouth College

Juhani T. Linnainmaa

USC Marshall School of Business; National Bureau of Economic Research (NBER)

Valeri V. Nikolaev

University of Chicago Booth School of Business

Date Written: February 27, 2017

Abstract

Book value of equity consists of two main parts: retained earnings and contributed capital. Retained earnings-to-market subsumes book-to-market's predictive power in the cross section of stock returns, despite comprising only 42% of book value on average. Contributed capital has no predictive power. Retained earnings represent the difference between accumulated past earnings and accumulated past dividends. We find that the predictive power of retained earnings arises entirely from accumulated past earnings. Our results imply that book-to-market predicts returns because it is a proxy for earnings yield (Ball, 1978). These results cast doubt on the notion that book-to-market identities over- and undervalued securities.

Keywords: G11, G12, M41

JEL Classification: Book-to-market, Contributed capital, Earnings yield, Mispricing, Retained earnings, Value premium

Suggested Citation

Ball, Ray and Gerakos, Joseph J. and Linnainmaa, Juhani T. and Nikolaev , Valeri V., Earnings, Retained Earnings, and Book-to-Market in the Cross Section of Expected Returns (February 27, 2017). Chicago Booth Research Paper No. 17-03. Available at SSRN: https://ssrn.com/abstract=2924798 or http://dx.doi.org/10.2139/ssrn.2924798

Ray Ball

University of Chicago - Accounting ( email )

Joseph J. Gerakos

Tuck School of Business at Dartmouth College ( email )

Hanover, NH 03755
United States

Juhani T. Linnainmaa

USC Marshall School of Business ( email )

Marshall School of Business
Los Angeles, CA 90089
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Valeri V. Nikolaev (Contact Author)

University of Chicago Booth School of Business ( email )

5807 South Woodlawn Avenue
Chicago, IL 60637
United States

HOME PAGE: http://faculty.chicagobooth.edu/valeri.nikolaev/index.html

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