Size and Book-to-Market Factors in Earnings, Cash Flows and Stock Returns: Empirical Evidence for the UK

Abstract

This study examines empirically the Fama and French three-factor model of stock returns using UK data during the period 1992-2001. Moreover, it examines whether the behavior of stock prices, in relation to size (market value of equity, ME) and book-to-market equity (BE/ME), reflects the behavior of earnings and cash flows, using earnings to book-to-market equity (EI/BE) as a profitability ratio and cash flows to book-to-market equity (CF/BE) as a performance ratio. It also examines whether stock prices forecast the reversion of earnings and cash flows growth observed after firms are ranked on size and BE/ME, using earnings to market equity (EI/ME) and cash flows to market equity (CF/ME) as growth ratios. The major objective of this study is to provide evidence that would contribute to the effort of explaining the 3FM in a common law country that does have financial reporting differences from the US. Our findings reveal a significant relationship between market, size and book-to-market equity factors and expected stock returns in the UK market. Moreover, consistent with rational pricing we find that BE/ME is a strong indicator of profitability (EI/BE) and performance (CF/BE). High BE/ME signals persistent poor earnings and cash flows and low BE/ME signals strong earnings and cash flows. Also, both profitability and performance ratios relate in the same way to size conditional on BE/ME and we find evidence that there is a size and a BE/ME factor in fundamentals (EI/BE, CF/BE) that may lead to a size and a BE/ME related risk factors in returns. Finally, we find evidence that stock prices forecast the reversion of earnings and cash flows growth observed after firms are ranked on size and BE/ME.