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

Accounting theory suggests that equity book-to-market ratios (BTM) should not exceed one if a firm’s return on equity exceeds its cost of capital or if it employs conservative accounting.  Yet, BTM is above one for many firms, particularly in recession years.  Recession risk is the extent to which a firm’s equity returns are more sensitive to market returns during recessions than at other times, which could result in BTM above one.  Thus, we address whether recession 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 explained by a modified version of HML, the BTM-based return explanation 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 recession 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 explanation 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.