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RR91 - Conservative accounting - the book-to-market ratio and stock returns
Derry Cotter and Ray Donnelly, 2006
Executive summary
This report examines the link between accounting conservatism and the difference between the accounting or book value of equity and its market value. In this report we reflect this difference using the book-to-market ratio. Although in some contexts ease of understanding dictates that we refer to the reciprocal of the book-to-market ratio, ie the market-to-book ratio instead. The focus here is on the influence of accounting choices pertaining to asset valuation on the book-to-market ratio. In addition, the report examines the predictive role of the book-to-market ratio of UK companies for future share price performance.
In Chapter 2 the stock market value of equity shares is shown to be a function of the balance sheet value of equity shareholders’ funds (ie book value), and expected future profitability. Current earnings have value relevance in so far as they influence expectations of future profitability.
Evidence of accounting conservatism is documented in Chapter 3 by analysing the factors that determine the information contained in company balance sheets. This information is influenced by corporate reporting requirements; by the exercise of judgement and decision-making by management; and by the existence and effectiveness of policing and enforcement mechanisms.
Reporting requirements, based primarily on a transaction-based historical cost system, are found to have evolved largely within an accountancy profession steeped in an ethos of conservatism. There is evidence, since the mid 1990s, of a shift towards a fair value system of asset measurement, but its adoption is being hampered by concerns over the reliability of information.
Empirical tests conducted on the choice of accounting policies provide evidence of conservatism in balance sheet asset values, market values being found to be significantly higher than book values in all years from 1987 to 2002. Positive skewness in the market-to-book value ratio in later years indicates that book value severely understates market value for some firms towards the end of the period.
Thus, this report finds that UK asset book values have been conservatively estimated, and evidence is also provided that managers exercised a conservative policy of asset valuation during 1987–2000. As noted above, the market value of equity shares is a function of the balance sheet value of equity shareholders’ funds (ie book value) and expected future profitability. Given the conservative approach towards asset valuation in the financial statements of UK companies, this suggests that any stock overpricing is likely to result either from over-optimistic estimates of future profitability or from irrational behaviour on the part of investors. Companies that had the lowest book-to-market ratios when the market peaked in 2000 were those whose share price subsequently suffered the greatest falls. Therefore, the probability of overpricing appears to be negatively related to the size of the book-to-market ratio.
The results of empirical tests on variables that are believed to provide an explanatory link between market values and book values are reported in section 4.3 of Chapter 4. These results provide confirmation that accounting conservatism, as measured in this report, is negatively related to the book-to-market ratio. This means that as managers choose accounting policies that attribute conservative values to assets, book values become smaller as a proportion of market values.
Equity returns over the three previous years are similarly found to be negatively related to the book-to-market ratio, as is the present value of the forecast book return on equity over the subsequent two years. The latter variable is not, however, found to be significant in the three years when the stock market reached its peak around 2000, which may be indicative of some irrationality in prices at this time.
Surprisingly, equity returns over the subsequent years are significant (in explaining the book-to-market ratio) only in 1987 and 2000. Further tests provide evidence of a stronger link between the book-to-market ratio and future returns when the latter are measured over a long period.
The relationship between the book-to-market ratio and subsequent share returns is further examined in section 4.4 of Chapter 4. Average abnormal returns (ie risk-adjusted share price changes) in the years 1999 to 2003 were significantly higher for high book-to-market companies (known as value stocks). This differential between growth (low book-to-market) and value stocks is concentrated in the periods in which earnings announcements are made.
Further investigation provides evidence that the relationship between the book-to-market ratio and future share price performance is a long-run effect, and that it is applicable only when there are negative earnings’ surprises. Thus, the book-to-market ratio explains cross-sectional differences in returns only for windows longer than one year, and for firms whose earnings are disappointing.
Finally, while accounting policy choice by management affects a company’s book-to-market ratio, no evidence is found that accounting policy choice affects future share returns. Accounting conservatism is not a useful explanatory variable for predicting future share returns.