Is the Book‐to‐market Ratio a Measure of Risk?

Abstract

We develop a leverage-based alternative to traditional asset pricing models to investigate whether the book-to-market ratio acts as a proxy for risk. We argue that the book-to-market ratio should act as a proxy because of the expected relations between (1) financial risk and measures of capital structure based on the market value of equity and (2) asset risk and measures of capital structure based on the book value of equity. We find no relation between average stock returns and the book-to-market ratio in all-equity firms after controlling for firm size, and an inverse relation between average stock returns and the book-to-market ratio in firms with a negative book value of equity. 2005 The Southern Finance Association and the Southwestern Finance Association.

Financial leverage and stock returns: evidence from an emerging economy

“…Peterkort and Nielsen (2005) analysed the factors that could have contributed towards the existence of value premium returns. They argued that book to market is a proxy of risk premium because of its expected relationship with financial leverage.…”

Risk‐based explanation for the book‐to‐market effect

“…Several studies provide empirical evidence to support this conjecture. Peterkort and Nielsen (2005) find an inverse relation between average stock returns and the book‐to‐market ratio in firms with a negative book value of equity (i.e. total liabilities exceed total assets).…”

An empirical framework of financial characteristics and outperformance in troubled economic times

“…By construction, the BM captures both financial and asset risk (Peterkort and Nielsen, 2005) and a larger BM would signal weak earnings and a smaller BM would signal strong earnings (Fama and French, 1995). Therefore, an empirical measure of BM is proposed to capture the effect of earnings' signals on outperformance of restaurant companies.…”