Going by the Book: Valuation Ratios and Stock Returns

Abstract

We show that continued reliance on firms' book-to-market ratios (B/M) in value investing, despite evidence of increasing noise in B/M, has wide-ranging effects on firms, market outcomes, and investment fund performance. Our study is motivated by the fact that major U.S. stock indexes and institutional funds continue relying on B/M when identifying value stocks and selecting index weights. Consistent with this reliance shaping market outcomes, we find firms' stock returns and trading volumes comove with B/M-peers (i.e., firms with similar B/M) in excess of their fundamentals, particularly among stocks held by value-oriented funds. Firms misidentified as value companies based on B/M also appear to have lower costs of capital. Finally, we show that investment funds that disproportionately rely on B/M earn predictably lower returns.

Keywords: Valuation; Market-to-book ratio; Value investing; Excess comovement

JEL Classification: G10, G11, G14, G20, M41