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BE/ME and E/P work better than ME/BE or P/E in regressions

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  • Musumeci, Jim
  • Peterson, Mark

Abstract

Researchers often form ratios of variables to measure firm characteristics, but which ratios create the most powerful tests? For example, if we use ratios of book value of equity (BE) and market value of equity (ME), or earnings (E) and price (P), does it matter which variable appears in the denominator? Any variable in the denominator, when close to zero, creates outliers and is less likely to produce effective tests. Our tests, using data from 1972 to 2008, indicate the choice between reciprocals often produces significantly different outcomes. While ME/BE is a more commonly used control variable than BE/ME or LN(BE/ME), we find the latter two produce better results, even if the data are trimmed to mitigate the outlier problem. Similarly, using E/P generally produces better results than P/E, and while ratios with book value of assets (BA) in the numerator work better than those with it in the denominator, the difference is less pronounced than when BE or E is part of the ratio. While the focus of our empirical findings is on growth measures, the principal applies anytime a ratio has a denominator that is frequently near zero.

Suggested Citation

  • Musumeci, Jim & Peterson, Mark, 2011. "BE/ME and E/P work better than ME/BE or P/E in regressions," Journal of Corporate Finance, Elsevier, vol. 17(5), pages 1272-1288.
  • Handle: RePEc:eee:corfin:v:17:y:2011:i:5:p:1272-1288
    DOI: 10.1016/j.jcorpfin.2011.06.003
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    Cited by:

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    3. Lien, Donald & Hung, Pi-Hsia & Lin, Zong-Wei, 2020. "Whose trades move stock prices? Evidence from the Taiwan Stock Exchange," International Review of Economics & Finance, Elsevier, vol. 66(C), pages 25-50.
    4. A. Dell’Acqua & L. L. Etro & E. Teti & P. Barbalace, 2013. "Market value and corporate debt: the 2006--2010 international evidence," Applied Financial Economics, Taylor & Francis Journals, vol. 23(6), pages 495-504, March.

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    More about this item

    Keywords

    Market-to-book; Book-to-market; Price-to-earnings ratio; Test specification; Tobin's Q; Control variable;
    All these keywords.

    JEL classification:

    • C10 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - General
    • C81 - Mathematical and Quantitative Methods - - Data Collection and Data Estimation Methodology; Computer Programs - - - Methodology for Collecting, Estimating, and Organizing Microeconomic Data; Data Access
    • G30 - Financial Economics - - Corporate Finance and Governance - - - General

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