Going by the Book: Valuation Ratios and Stock Returns

  • Choi, So and Wang
  • Working Paper, 2021
  • A version of this paper can be found here.
  • Want to read our summaries of academic finance papers? Check out our Academic Research Insight category

What are the Research Questions?

Book to Market (B/M) has been a prominent indicator used to construct “value” tilted portfolios. The love affair with B/M started with Graham and Dodd (1934), but became the gold standard after Fama and French (1992). Historically, B/M was a reasonable ratio to express the value factor and it worked incredibly well when investors were hunting for value in steel mills, railroads, and textile companies. Book value served as a reasonable proxy for earnings power. However, we are now living in an economy where public companies’ most valuable “assets” are intellectual property, brand recognition, and customer loyalty, which are typically omitted from firms’ balance sheets and difficult to put a book value on (See Kai Wu post). As a consequence, book values are progressively becoming less relevant.

The authors ask the following research questions:

  1. Is B/M becoming increasingly detached from common alternative valuation ratios?
  2. Is B/M becoming worse at forecasting future returns and growth in both an absolute and relative sense?
  3. Are Indices and institutional funds still using B/M as a prominent ratio to build “value” strategies?
  4. Possible solutions?

What are the Academic Insights?

By studying data from Compustat, CRSP, and Thomson Reuters S12 ownership data, the authors end with a final sample of 84,837 firm-year observations from 1980 to 2017. The authors find the following:

1. YES-the correlations between B/M and a series of benchmarks steadily declined over time, consistent with B/M becoming a noisier signal of stocks’ value status. For example, the average cross-sectional correlation between B/M and a composite of sales-to-price, gross-profit to-price, and net payouts to shareholders-to-price fell from approximately 0.7 to 0.45 during the 1980 to 2017 sample period. This trend of gradual detachment between the ratios coincides with a steady increase in firms’ off-balance-sheet intangible assets, goodwill, and stock issuances and repurchases.

2. YES- Findings show that B/M has become a noisier measure of expected returns and growth, particularly in cases where it deviates from benchmark valuation ratios (that is cases where firms appear as value firms in terms of B/M but as glamour firms in terms of other value metrics).

3. YES- excess comovements in firms’ returns and trading volumes are strongest among stocks held by more value-oriented funds that trade based on B/M.

4. With appropriate adjustments, investors can improve the usefulness of B/M in value strategies. For example by adjusting book value for investments (i.e., capitalizing expenditures) in intellectual and brand capital, and goodwill.

Why does it matter?

If your reading this post, chances are you’ve been tasked with utilizing Book to Market as a valuation tool in one form or the other. This paper highlights the existence of institutional inertia that has been slow to adapt to new secular trends in the economy. In fact, the analysis finds that many market participants continue to rely on signals that previously worked well, despite a steady decline in signal content, and/or signals that serve as a very noise signal for earnings power (see our piece on EBIT/TEV).

The Most Important Chart from the Paper:

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index.


We study the use of firms’ book-to-market ratios (B/M) in value investing and its implications for comovements in firms’ stock returns and trading volumes. We show B/M has become increasingly detached from common alternative valuation ratios over time while also becoming worse at forecasting future returns and growth in both an absolute and relative sense. Despite these trends, some major U.S. stock indexes and institutional funds continue relying on B/M when identifying value stocks and selecting index weights. Consistent with this reliance shaping market outcomes, we find firms’ stock returns and trading volumes comove with B/M-peers (i.e., firms with similar B/M) in excess of their fundamentals, particularly among stocks held by value-oriented funds. A shift in the economy toward firms investing in knowledge and organizational capital and increasing shareholder payouts contribute to these trends. Finally, we highlight simple adjustments to B/M that mitigate these issues.