A framework for identifying accounting characteristics for asset pricing models, with an evaluation of book-to-price

European Financial Management

Accounting

European Financial Management 2018 Vol 24:4 p 488-520

2018

We provide a framework for identifying accounting numbers that indicate risk and expected return. Under specified accounting conditions for measuring earnings and book value, book-to-price (B/P) indicates expected returns, providing justification for B/P in asset pricing models. However, the framework also points to earnings-to-price (E/P) as a risk characteristic. Indeed, E/P, rather than B/P, is the relevant characteristic when there is no expected earnings growth, but the weight shifts to B/P with growth. Using this framework we resolve a puzzle: in contrast to previous empirical research, we find that leverage is positively associated with future returns, as predicted by theory.

Accounting principles; Book-to-price; Earnings-to-price; Growth and risk

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