Biases and Lags in Book Value and Their Effects on the Ability of the Book-to-Market Ratio to Predict Book Return on Equity
Posted: 29 Nov 1999
Abstract
We distinguish two sources of variation in the book-to-market ratio (BTM) -- bias and lags -- with different implications for future book return on equity (ROE). We hypothesize that the bias and lag components of the BTM both have negative implications for future ROE, but the bias component's implications persist while the lag component's implications decay over the period that the firm's currently unrecognized economic gains or losses are recognized. We forecast ROE over horizons from one to five years and the terminal value in the discounted residual income valuation model at a five-year horizon, and find results generally consistent with our hypotheses. We also predict and find that the association between the bias (but not the lag) component and future ROE is less negative for higher growth firms.
JEL Classification: M41, G12
Suggested Citation: Suggested Citation