Returns to Buying Earnings and Book Value: Accounting for Growth

This paper provides an explanation of how the earnings yield and book-to-price combine to indicate required equity returns, along with empirical support. Earnings yields predict returns, consistent with standard formulas that show that the earnings yield equals the required return when there is no expected earnings growth beyond that from retention. With growth, those same formulas show that the earnings yield is increasing in the required return but decreasing in the growth, and that growth can be accommodated in inferring the required return. However, if growth is risky and so requires a higher return, growth has both an increasing and decreasing effect on the earnings yield, making the determination of the required return from a given earnings yield problematical. The paper shows that book-to-price facilitates the determination: for a given earnings yield, bookto-price indicates additional return associated with expected growth. This finding provides a rationalization of the well-documented book-to-price effect in stock returns: book-to-price indicates the risk in buying earnings and earnings growth. Book-to-price is positively associated with earnings yields (that indicate expected returns) but, in addition, book-to-price indicates risky growth that adds to expected returns. Growth identified by a high book-to-price as yielding a higher return is quite different, however, from “growth” typically attributed to a low book-to-price as yielding a lower return. Accordingly, the notion of “growth” versus “value” is redefined.