Why Does the Ratio of Book to Market Value of Equity Explain Cross-Section Stock Returns?

Paper number: 96/09

Paper date: March 1996

Year: 1996

Paper Category: Discussion Paper

Authors

George Bulkley
University of Exeter

Richard Harris
University of Exeter

Abstract

A number of papers have reported evidence that cross-section stock returns can be explained by the ration of the book value of complanies' assets to their market value. The unresolved issue, which we address here, is whether this evidence is consistent with the efficient markets hypothesis. We argue that the efficient markets model, which implies that book to market is a proxy for risk, implies also that it is a noisy proxy. This same model also presents a way to clean up this variable so that it explains stock returns more successfully. Removing the noise from book to market in this way should improve its explanatory power under the efficient markets hypothesis, while under the alternative hypothesis of irrational pricing it should cause its explanatory power to deteriorate. We present evidence in this paper that its explanatory power deteriorates.

JEL Classification Nos: C33, G14
Keywords: Book to market, Cross-section returns, Panel data

Corresponding Author: Richard Harris, Department of Economics, University of Exeter, Amory Building, Rennes Drive, EXETER EX4 4RJ,Great Britain, tel:(44) 1392 263215, fax: (44) 1392 263242, email: R.D.F.Harris@exeter.ac.uk