- Wealth PMS (50L+)
This is a guest post by Anand Shekhar. Anand is the Head of Research & Development at Centre for Analytical Finance, Indian School of Business. He completed his B.E. in Mechanical Engineering from BITS Pilani and PGP with major in Finance from Indian School of Business. He has been interested in investing and personal finance right from his school days and aspires to contribute in research and academia in Finance.
Financial ratios are used to objectively understand and asses the health of companies. Different ratios are used for different assessments around profitability, operational efficiency, leverage etc.
Once such ratio is Book-To-Market (BM) which is:
The ratio of book value of Equity to market value of Equity (share price).
BM ratio is generally used to understand the relative valuation of a firm. There are other inferences which can be drawn using BM ratio but the most famous connotation revolving around it is related to valuation.
High BM ratio is associated with favourable valuation (cheap or fairly priced stocks) whereas low BM ratio is associated with pricey valuation (overpriced stocks).
Therefore, BM ratio is widely considered as an indicator for future returns. Specifically, high BM ratio is a predictor of high future returns.
No ratio is complete in itself and each ratio suffers from drawbacks. While different ratios provide unique insights into a stock, they are also often misused and misinterpreted. It is important to understand the ratio in depth to separate the wheat from the chaff.
There is enough critique around BM ratio as well and it is important for investors using it to understand what BM ratio actually conveys. This article aims to unravel the fundamentals of BM ratio, why it works and how to use it.
The contents of this article are based on a recent research paper (henceforth referred to as “paper”) titled “Earnings, retained earnings, and book-to-market in the cross section of expected returns” published in January 2020 edition of Journal of Financial Economics.
Let’s unpack Book-To-Market.
Market value of equity is nothing but the market capitalization (share price x number of shares outstanding) of a firm.
Book value of equity is equal to assets minus liabilities of a firm i.e. the claim of equity holders on the assets of the firm after deducting all the liabilities.
Book value of equity can be broken down into three components –
Based on historical analysis of firms in the US, contributed capital represents a larger percentage of the book value of equity (54%), retained earnings are 41% of the book value of equity and AOCI represents the smallest share of the book value of equity, with a mean of 5%.
Since AOCI is just a small portion of book value of equity and is unrelated to operations of the firm, we do not need to pay much heed to it.
Book value of equity is an accounting term and does not convey much information about the valuation of the firm. Benjamin Graham and David Dodd, in their famous book “Security Analysis” (first published in 1934), mention that value investors should not use book value as a measure of intrinsic value (true value) of a firm.
If book value of equity does not capture intrinsic value of the firm, how is BM ratio successful in predicting future returns?
The paper argues that the predictive power of BM ratio comes from retained earnings portion of book value of equity.
Since retained earnings is an accumulation of past earnings of the firm, it has an inherent averaging effect which mitigates transitionary earnings effects.
This is the crux of the paper and let us understand this in detail.
Firms follow accrual-based accounting and the preparation of income statement involves various assumptions such as expected sales returns, expected write-offs on accruals etc. Various such items which require assumptions can be easily manipulated by managers of the firm to inflate the earnings in a given year.
But such spurious assumptions eventually manifest at a later time and consequently depress future earnings. Hence, such manipulations are transitionary, and these are the transitionary earnings effects highlighted in the paper.
Since retained earnings are accumulation of earnings over the years, the effect of said transitionary effects are mitigated.
Hence, retained earnings better represents actual earnings ability of the form, free from short-term transitionary effects, and predict future earnings. Contributed capital and AOCI have no such predictive power.
Thus, retained earnings to market ratio (ratio of retained earnings to market value of form) subsumes predictive power of BM ratio. The paper concludes that the predictive power of retained earnings to market ratio is a better indicator of future returns compared to BM ratio and is valid across various countries and time periods.
Asness et al. (2015) and Fama and French (2016) show that book-to-market is a not a significant predictor of returns after 1990 i.e. the predictive power of BM ratio decreases in the post 1990 period. Whereas retained earnings to market (RM) ratio is a significant predictor right from 1934 to 2019.
Further investigation in the reason behind BM ratio losing its predictive power post 1990 reveals that the correlation between retained earnings and book value of equity started decreasing post 1990. This further strengthens the argument that RM ratio is a better predictor of future returns and the predictive power of BM ratio is due to its retained earnings component.
The paper draws five major conclusions.
Knowing that RM ratio is a better predictor of future returns, how are investors supposed to use it? Ideally, investors should prefer RM ratio over BM ratio while analysing stocks to pick (along with other indicators; any single indicator is not as good as combination of indicators).
The caveat is that RM ratio is not as readily available as BM ratio and needs explicit computation. But if there’s one take away from this article, it’s that the required effort is worth it.
A quick snapshot of the NIFTY 50 from March 2019
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