The dynamics of firms' abnormal earnings and the growth differential between market and book value of equity

In this study, I investigate the relationship between firms’ real performance in the product market and their valuation in the stock market, employing a framework that extends beyond those used in previous research. Drawing on a combination of time-series and cross-sectional data from 1046 US firms over the period 2000–2021, I find that the persistence of abnormal earnings is a key driver of long-term stock market valuation. Specifically, sustained positive abnormal earnings are associated with market values growing more rapidly than book values, leading to an increasing divergence between the two. However, this divergence persists only up to a certain threshold. Firms that consistently generate abnormal earnings tend to gain greater investor confidence, as such performance signals efficient resource utilization and/or an ability to leverage market power to outperform average or expected benchmarks. In addition to abnormal earnings, I find that factors such as firm size, investment rate, price-to-earnings ratio, leverage ratio, dividend yield, and earnings variability also significantly influence the growth differential between market and book values.