Going by the Book: Valuation Ratios and Stock Returns

46 Pages Posted: 28 May 2021

See all articles by Ki-Soon Choi

Ki-Soon Choi

Massachusetts Institute of Technology (MIT) - Sloan School of Management

Eric C. So

Massachusetts Institute of Technology (MIT) - Sloan School of Management

Charles C. Y. Wang

Harvard Business School (HBS)

Date Written: May 26, 2021

Abstract

We study the use of firms' book-to-market ratios (B/M) in value investing and its implications for comovements in firms’ stock returns and trading volumes. We show B/M has become increasingly detached from common alternative valuation ratios over time while also becoming worse at forecasting future returns and growth in both an absolute and relative sense. Despite these trends, some 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. A shift in the economy toward firms investing in knowledge and organizational capital and increasing shareholder payouts contribute to these trends. Finally, we highlight simple adjustments to B/M that mitigate these issues.

JEL Classification: G10, G11, G12, G14, M40, M41

Suggested Citation

Choi, Ki-Soon and So, Eric C. and Wang, Charles C. Y., Going by the Book: Valuation Ratios and Stock Returns (May 26, 2021). Available at SSRN: https://ssrn.com/abstract=3854022 or http://dx.doi.org/10.2139/ssrn.3854022

Ki-Soon Choi

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
E62-416
Cambridge, MA 02142
United States

Eric C. So (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
E62-416
Cambridge, MA 02142
United States

Charles C. Y. Wang

Harvard Business School (HBS) ( email )

Soldiers Field
Boston, MA 02163
United States

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