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Book‐to‐Market Components, Future Security Returns, and Errors in Expected Future Earnings

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  • Bruce K. Billings
  • Richard M. Morton

Abstract

This study investigates whether the ability of book‐to‐market to predict returns derives from systematic errors in the market’s expectation of future earnings. We extend Beaver and Ryan (1996, 2000) by decomposing book‐to‐market into a more persistent (bias) component and a delayed recognition (lag) component. We find that both components are related to analyst expectations of future earnings, but the lag component is the dominant factor across all forecast horizons. Similarly, we find that the lag component explains most of the inverse relation between book‐to‐market and future returns. Given that lag is constructed by regressing book‐to‐market ratios on lagged price changes, our results are consistent with the lag component capturing systematic stock price reversals. We find that the components have unique relations with subsequent earnings forecast revisions, and controlling for these relations substantially mitigates the components’ ability to predict returns. Our component‐level analysis provides insight into how expected future earnings, summarized in book‐to‐market ratios help to explain this market anomaly.

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  • Bruce K. Billings & Richard M. Morton, 2001. "Book‐to‐Market Components, Future Security Returns, and Errors in Expected Future Earnings," Journal of Accounting Research, Wiley Blackwell, vol. 39(2), pages 197-219, September.
    • Handle: RePEc:bla:joares:v:39:y:2001:i:2:p:197-219
    DOI: 10.1111/1475-679X.00009
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    Cited by:

    1. Keng Lo & Yu Lan, 2010. "An approach to the R&D value based upon real option method," Quality & Quantity: International Journal of Methodology, Springer, vol. 44(3), pages 509-527, April.
    2. Jana Smith Raedy & Philip Shane & Yanhua Yang, 2006. "Horizon†Dependent Underreaction in Financial Analysts' Earnings Forecasts," Contemporary Accounting Research, John Wiley & Sons, vol. 23(1), pages 291-322, March.
    3. Colin Clubb & Mounir Naffi, 2007. "The Usefulness of Book‐to‐Market and ROE Expectations for Explaining UK Stock Returns," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 34(1‐2), pages 1-32, January.
    4. Dana Hollie & Philip B. Shane & Qiuhong Zhao & Steven Cahan, 2017. "The role of financial analysts in stock market efficiency with respect to annual earnings and its cash and accrual components," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 57(1), pages 199-237, March.
    5. Ramnath, Sundaresh & Rock, Steve & Shane, Philip, 2008. "The financial analyst forecasting literature: A taxonomy with suggestions for further research," International Journal of Forecasting, Elsevier, vol. 24(1), pages 34-75.
    6. Brown, William O. & Helland, Eric & Smith, Janet Kiholm, 2006. "Corporate philanthropic practices," Journal of Corporate Finance, Elsevier, vol. 12(5), pages 855-877, December.
    7. Zaremba, Adam & Kizys, Renatas & Tzouvanas, Panagiotis & Aharon, David Y. & Demir, Ender, 2021. "The quest for multidimensional financial immunity to the COVID-19 pandemic: Evidence from international stock markets," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 71(C).

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