2021
Working Paper
HBS Working Paper Series

Going by the Book: Valuation Ratios and Stock Returns

By: Ki-Soon Choi, Eric So and Charles C.Y. Wang

Format:Print
| Language:English

Abstract

We study the use of firms’ book-to-market ratios (B/M) in value investing and its implications for comovements in firms’ stock returns and trading volumes. We show B/M has become increasingly detached from common alternative valuation ratios over time while also becoming worse at forecasting future returns and growth in both an absolute and relative sense. Despite these trends, some major U.S. stock indexes and institutional funds continue relying on B/M when identifying value stocks and selecting index weights. Consistent with this reliance shaping market outcomes, we find firms’ stock returns and trading volumes comove with B/M-peers (i.e., firms with similar B/M) in excess of their fundamentals, particularly among stocks held by value-oriented funds. A shift in the economy toward firms investing in knowledge and organizational capital and increasing shareholder payouts contribute to these trends. Finally, we highlight simple adjustments to B/M that mitigate these issues.

Keywords

Valuation Ratios; Book-to-market Ratios; Investment Return; Investment; Decision Making

Citation

Choi, Ki-Soon, Eric So, and Charles C.Y. Wang. "Going by the Book: Valuation Ratios and Stock Returns." Harvard Business School Working Paper, No. 21-126, May 2021.