Equity Book-to-Market Ratios Above One and Macroeconomic Risk

Equity book-to-market ratios (BTM) should not exceed one if a firm’s return on equity exceeds its cost of capital or it employs conservative accounting.  Yet, BTM is above one for many firms, particularly in recession years.  We address whether macroeconomic risk helps explain this apparent incongruity.  We find that BTM above one generates predictable returns and that these returns (i) are concentrated in recession years; (ii) are not explained by HML, the BTM-based return prediction factor; and (iii) likely reflect risk rather than mispricing.  We also find that returns of firms with BTM above one are more sensitive to expected market risk premiums during recessions.  In addition, we find BTM above one reflects potentially overstated equity book values, but only in non-recession years.  In contrast, high BTM below one does not generate predictable returns and reflects potentially overstated equity book values in recession and non-recession years.  Together, our findings reveal that macroeconomic risk helps explain BTM above one, which means that BTM above one has implications for risk assessment, return prediction, and asset under-impairment identification.  Our study calls into question using HML as a return prediction factor for BTM above one and using BTM as a generic measure of conservative accounting or as the key indicator of overstated asset book values.