The Information Content of the Book-to-Market Ratio

This article explores whether the correlation between risk and the market value of equity can explain the premium obtained by investment strategies based on the ratio of book value to market value of equity (BV/MV). Using data from the Japanese stock market, I show that the relationship between BV/MV and risk is weak. I find that two factors contribute to this result. First, market value correlates not only with risk but also with variables measuring liquidity and past performance. Second, book value of equity has a strong correlation with financial risk. Overall evidence suggests that the high correlation between book value and risk reduces the role of market value as a risk proxy and makes other information contained in market value appear to be the main source of the BV/MV premium. The relationship between risk and the market value of equity (MVE) is now commonly accepted in the financial community. It has been used to explain the “size effect” and to construct risk factors for asset-pricing models. As defined by the discounted cash flow model, however, MVE reflects not only risk (the discount rate) but also current market expectations of future cash flows. Because two pieces of information are embedded in MVE, researchers who are trying to use the risk contained in MVE must incorporate a variable as a proxy for market expectations. The natural choices for proxies of future performance are accounting variables. When these variables are used, however, the discounted cash flow model implies that the strong association between stock returns and the ratios constructed with MVE and the accounting variables may be a result of the risk content of MVE. In the study reported here, I used 33 years of data from the Japanese stock market to explore this issue.The article starts with a discussion of the information content of MVE. Initial results show that the association between risk and MVE depends on the type of variable used to control for market expectations. When variables based on physical size (total assets, amount of sales, and so on) are used, the association between risk and MVE is strong. When variables based on earnings (net income, cash flows, book value of equity) are used, the relationship is weaker.Results shown here also indicate that when physical size is controlled for, MVE correlates with financial risk (measured by leverage and earnings volatility), with market risk (measured by market beta and volatility of stock returns), and with other signs of distress (such as the proportion of companies reducing dividends in the portfolio). In addition to these measures of risk, however, MVE also correlates with variables used to measure liquidity and with variables commonly used to form expectations, such as past growth and past returns. Moreover, additional tests suggest that the market extrapolates past performance. Therefore, the evidence here is that both risk and expectations are factors affecting MVE and, consequently, stock returns.I found also that when accounting variables are combined with MVE in a ratio, the physical size variables yield significant relationships between risk and the ratios. Nevertheless, if book value of equity is used to control for expected cash flows, the association between risk and the ratio of book value to market value (BV/MV) is low. Of the seven risk variables I used, only one presented a pattern consistent with the idea that the BV/MV premium arises from risk. To the contrary, I found the association between BV/MV and the variables for liquidity and past performance to be very strong, which suggests that such variables are the only cause of the BV/MV premium.To further investigate this issue, I explore the information content of book value of equity (BVE). My tests show that, beyond its association with physical size, this variable correlates strongly with the seven measures of risk I used in this research. Therefore, in addition to the relationship between MVE and expectations, the strong association between risk and BVE is a cause of the weak relationship between risk and BV/MV.Overall results discussed in the article suggest that the premium obtained by MVE and by ratios formed with accounting variables and MVE is caused not only by risk but also by such factors as liquidity and the market's expectations for the company's future. When book value of equity is used to control for expectations, however, the high correlation between BVE and risk automatically controls one part of the asset's total risk, causing MVE to function less as a risk proxy and more as a reflection of market expectations.