۱٫ Introduction

۲٫ Book value of equity, retained earnings, and contributed capital

۳٫ Data

۴٫ The cross section of returns

۵٫ Portfolio sorts

۶٫ Retained earnings and contributed capital factors

۷٫ Evidence that earnings yield is the source of the retained earnings and value premiums

۸٫ Predicting average returns over increasing horizons

۹٫ Results for different samples

۱۰٫ Functional fixation

۱۱٫ Conclusion

Appendix A. Share issuances

Appendix B. Share repurchases

Appendix C. World excluding U.S. data

References

Abstract

Book value of equity consists of two economically different components: retained earnings and contributed capital. We predict that book-to-market strategies work because the retained earnings component of the book value of equity includes the accumulation and, hence, the averaging of past earnings. Retained earnings-to-market predicts the cross section of average returns in U.S. and international data and subsumes book-to-market. Contributed capital-to-market has no predictive power. We show that retained earnings-tomarket, and, by extension, book-to-market, predicts returns because it is a good proxy for underlying earnings yield (Ball, 1978; Berk, 1995) and not because book value represents intrinsic value.

Introduction

The book-to-market ratio has long been used as an indicator of value. We predict that book-to-market strategies work because the book value of equity includes the accumulation and, hence, the averaging of past earnings. Our thesis is that this averaging attenuates timing issues in accounting measurement and transitory real factors that affect individual-year earnings, resulting in a better proxy for the firm’s underlying earnings yield (Ball, 1978; Berk, 1995). Consistent with our thesis, we show that book-to-market predicts returns only because it contains retained earnings-to-market and retained earnings contain past earnings. This result confirms the conjecture of Graham and Dodd (1934) that value investors should not use book value as a measure of intrinsic value. Instead, they should develop measures of a firm’s average earnings power by removing transitory real effects such as current business conditions, and transitory accounting effects such as one-time items and manager manipulation.

We start with the observation that the book value of equity consists of two main parts: contributed capital and retained earnings. These parts are of approximately equal size but represent different economic constructs. The contributed capital component records the net capital transactions between the firm and its shareholders and, hence, comprises accumulated past equity issuances less past share repurchases. The fact that investors contributed capital to a firm does not necessarily reveal information about the firm’s riskiness. It merely indicates that investors were prepared to bear such risk. Recent net issuances could, however, lead to a negative relation between contributed capital and stock returns.1 We therefore predict either no relation or a weak negative relation between contributed capital and the cross section of expected returns.