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

Penman, S H, Reggiani, F, Richardson, S A and Tuna, I (2018) A framework for identifying accounting characteristics for asset pricing models, with an evaluation of book-to-price. European Financial Management, 24 (4). pp. 488-520. ISSN 1354-7798

Abstract

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.