Going by the Book: Valuation Ratios and Stock Returns

Abstract

I explore how institutional frictions interact with the changing nature of the book value of equity to impact stock returns. I first find that book-to-market is relatively less informative of future returns when it significantly deviates from other valuation multiples, and employing refined signals improve return predictability. Then, I find that a firm’s stock returns are still strongly correlated with its book-to-market portfolio returns even when book-to-market is less informative. Together, my findings suggest that institutional investors follow “brand indices” that overweight firms’ book-to-market to attract capital, which induces excess correlations along the book-to-market dimension, even when book-to-market is less informative of long-term future returns.