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

66 Pages Posted: 1 Mar 2017 Last revised: 10 Sep 2018

Ray Ball

University of Chicago - Booth School of Business

Joseph J. Gerakos

Tuck School of Business at Dartmouth College; Dartmouth College - Tuck School of Business

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: September 5, 2018

Abstract

Book value of equity consists of two economically different components: retained earnings and contributed capital. We predict that book-to-market strategies work because the retained earnings component of the book value of equity includes the accumulation and, hence, the averaging of past earnings. Retained earnings-to-market predicts the cross section of average returns in U.S. and international data and subsumes book-to-market. Contributed capital-to-market has no predictive power. We show that retained earnings-to-market -- and, by extension, book-to- market -- predicts returns because it is a good proxy for underlying earnings yield (Ball, 1978; Berk, 1995) and not because book value represents intrinsic value.

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 (September 5, 2018). Journal of Financial Economics (JFE), Forthcoming. Available at SSRN: https://ssrn.com/abstract=2924798 or http://dx.doi.org/10.2139/ssrn.2924798

Ray Ball

University of Chicago - Booth School of Business ( email )

Joseph J. Gerakos

Tuck School of Business at Dartmouth College ( email )

Hanover, NH 03755
United States

Dartmouth College - Tuck School of Business ( 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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