44 Pages Posted: 1 Mar 2017 Last revised: 8 Mar 2017
Date Written: February 27, 2017
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: 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