Accounting Ratios and the Cross-section of Expected Stock Returns

Under clean-surplus accounting, the log return on a stock can be decomposed into a linear function of the contemporaneous log return on equity, the contemporaneous log dividend–price ratio (if the stock pays a dividend), and both the contemporaneous and lagged values of the log book-to-market equity ratio. This paper studies the implications of this decomposition for the cross-section of conditional expected stock returns. The empirical analysis reveals that the log accounting ratios capture cross-sectional variation in both the conditional mean and conditional variance of log stock returns, which is consistent with the decomposition. It also brings fresh insights to the relation between firm size (market equity) and conditional expected stock returns. The evidence indicates that the conditional median return increases with firm size, while the conditional return skewness decreases with firm size. Empirically, the skewness effect outweighs the median effect, leading to the well-documented inverse relation between size and average returns. The results of out-of-sample tests suggest that investors could use the information provided by the observed values of the log accounting ratios to formulate more effective portfolio strategies.