A Framework for Identifying Accounting Characteristics for Asset Pricing Models, with an Evaluation of Book-to-Price

European Financial Management, Forthcoming

51 Pages Posted: 4 May 2017 Last revised: 26 Mar 2018

See all articles by Stephen H. Penman

Stephen H. Penman

Columbia Business School - Department of Accounting

Francesco Reggiani

University of Zurich

Scott A. Richardson

AQR Capital Management, LLC; London Business School

A. Irem Tuna

London Business School

Multiple version iconThere are 2 versions of this paper

Date Written: December 1, 2017

Abstract

The paper presents a framework for identifying accounting numbers that indicate risk and expected return. The framework establishes conditions under which book-to-price (B/P), so prominent in asset pricing, indicates expected returns: B/P indicates expected returns if it forecasts future earnings growth and the risk that the growth will not be realized. However, that condition is satisfied only under specific accounting conditions — it depends on the accounting for book value and associated earnings. The empirical analysis confirms that the conditions are satisfied under GAAP accounting, and so identifies book-to-price (B/P) as a valid risk characteristic for asset pricing. However, the framework also points to earnings-to-price (E/P) as a risk characteristic. Indeed, E/P, rather than B/P, is the relevant characteristic when there is no expected earnings growth, but the weight shifts to B/P with growth. The framework also enables the separation of the expected return for operating risk from that due to financing risk. With this separation, the paper revisits the puzzling negative relation that has been observed between leverage and realized returns, a finding that has been attributed to failure to control for operating risk. We find a positive relation between leverage and returns when operating risk characteristics identified by our framework are recognized.

Suggested Citation

Penman, Stephen H. and Reggiani, Francesco and Richardson, Scott Anthony and Tuna, Ayse Irem, A Framework for Identifying Accounting Characteristics for Asset Pricing Models, with an Evaluation of Book-to-Price (December 1, 2017). European Financial Management, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2962620 or http://dx.doi.org/10.2139/ssrn.2962620

Stephen H. Penman (Contact Author)

Columbia Business School - Department of Accounting ( email )

3022 Broadway
New York, NY 10027
United States
212-854-9151 (Phone)
212-316-9219 (Fax)

Francesco Reggiani

University of Zurich ( email )

Rämistrasse 71
Zürich, CH-8006
Switzerland

Scott Anthony Richardson

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

Ayse Irem Tuna

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

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