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Returns to buying earnings and book value: accounting for growth and risk

Author

Listed:
  • Stephen Penman

    (Columbia University)

  • Francesco Reggiani

    (Bocconi University)

Abstract

Historical cost accounting deals with uncertainty by deferring the recognition of earnings until the uncertainty has largely been resolved. Such accounting affects both earnings and book value and produces expected earnings growth deemed to be at risk. This paper shows that the earnings-to-price and book-to-price ratios that are the product of this accounting forecast both earnings growth and the risk to that growth. The paper also shows that the market pricing of earnings and book values in these ratios aligns with the risk imbedded in the accounting: the returns to buying stocks on the basis of their earnings yield and book-to-price are explained as a rational pricing of the risk of expected earnings growth not being realized. Accordingly, the paper provides a rationalization of the well-documented book-to-price effect in stock returns: book-to-price indicates the risk in buying earnings growth. However, growth identified by a high book-to-price as yielding a higher return in this paper is quite different from “growth” typically attributed to a low book-to-price as yielding a lower return. Accordingly, the notion of “growth” versus “value” requires modification.

Suggested Citation

  • Stephen Penman & Francesco Reggiani, 2013. "Returns to buying earnings and book value: accounting for growth and risk," Review of Accounting Studies, Springer, vol. 18(4), pages 1021-1049, December.
    • Handle: RePEc:spr:reaccs:v:18:y:2013:i:4:d:10.1007_s11142-013-9226-y
    DOI: 10.1007/s11142-013-9226-y
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    Cited by:

    1. Maureen McNichols & Madhav V. Rajan & Stefan Reichelstein, 2014. "Conservatism correction for the market-to-book ratio and Tobin’s q," Review of Accounting Studies, Springer, vol. 19(4), pages 1393-1435, December.

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    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • M41 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - Accounting

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