Equity book values should not exceed equity market values if a firm’s return on equity exceeds its cost of capital or it employs conservative accounting. Yet, equity book-to-market ratios greater than one (BTM > 1) are pervasive and persistent. We address whether BTM > 1 reflects low market values or high book values and, if so, why. We find BTM > 1 reflects low equity market values associated with macroeconomic risk, and thus generates higher hedge returns than equity book-to-market ratios less than one (BTM < 1). BTM > 1 also reflects potentially overstated equity book values. BTM < 1 generates positive hedge returns but these returns likely reflect mispricing. High BTM < 1 reflects potentially overstated equity book values but does not generate positive hedge returns. Together, our findings reveal BTM > 1 identifies risk and accounting characteristics different from those of other BTM levels and call into question using a single BTM-based factor to predict returns for BTM >1, BTM as a generic indicator of conservative accounting, and BTM > 1 as the key indicator of overstated asset book values.
|Number of pages||55|
|Publication status||In preparation - 2021|
- Book-to-market ratios
- Macroeconomic risk