There is A Growth Premium: Evidence from A Decomposition of Book-to-Market Ratio
49 Pages Posted: 19 Jun 2017 Last revised: 14 Apr 2020
Date Written: April 13, 2020
This paper proposes a time series decomposition of book-to-market ratio (BM) into a trend component and an innovation component (I_BM). Under the framework of stock valuation with growth options, we demonstrate that I_BM is negatively related to the change of growth options and therefore negatively related to the expected stock return. We document significant empirical evidence consistent with a growth premium as low IBM stocks earn significantly higher future returns, even after adjustment for risk factors and controlling for other predictors. Moreover, low I_BM firms convert more growth options and take on higher financial leverage in the future.
Keywords: Book-to-Market Ratio, Growth Option, Growth Premium, Innovation, Stock Return
JEL Classification: G12
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