Book-To-Market Ratio – Definition

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Book-to-Market Ratio Definition

The book-to-market ratio is a ratio used to determine the value of a company by comparing its book value to its market value.

The market value of a company is derived from the value (price) of its stock in the market. The book value is the accounting value of the company as stated in the balance sheet.

The calculation of the book value-to-market ratio is based on either.

Book-to-market ratio = book value of firm / market value of firm

Or

Book-to-market ratio = common shareholders’ equity / market capitalization

A Little More on Book-to-Market Ratio

The firm’s book value is calculated using the data from the company balance sheet. The book value is either accounting value or historical cost. Book value can be determined by the subtraction of total liabilities, preferred shares, and intangible assets from the company’s total assets. This means book value is the residual value of a company after it is wound up (shut down and sold off). Sometimes, some analysts use the capital value in the balance sheet as book value.

The market value of a publicly-traded stock is determined by multiplying its total number of outstanding shares by the existing share price.

The book-to-market ratio helps to identify the overvaluation or undervaluation of a firm’s securities. Any ratio above one indicates undervaluation of a stock, while any ratio below one shows overvaluation.

The inverse of this ratio is the market-to-book ratio, also known as the price to book ratio.

Academic Research on Book to Market Ratio

Biases and lags in book value and their effects on the ability of the book-to-market ratio to predict book return on equity, Beaver, W. H., & Ryan, S. G. (2000). Journal of accounting research, 38(1), 127-148. The author state in this paper that bias, meaning continuous higher or lower book value of a firm than its market value resulting in book-to-market ratio persistently above or lower one. Bias results from joint impacts of the accounting process and economic environment, for example, expected positive present value projections and inflation.

Firm size, book‐to‐market ratio, and security return: A holdout sample of financial firms, Barber, B. M., & Lyon, J. D. (1997). The Journal of Finance, 52(2), 875-883. The paper discusses the significant relationship between a company’s size, book-to-market ratios and security returns for non-financial companies. Farma and French left out financial companies in their analysis because of initial interest in leverage as an explanatory variable for security returns. This exclusion created a natural holdout sample on which robustness of financial companies is tested.

The author puts down that the relationship between firm size, book-to-market ratio, and security returns is the same for both financial and non-financial companies. Author last result showed that data-snooping and selection biases do not explain the size and book-to-market returns pattern.

Size and book‐to‐market factors in earnings and returns, Fama, E. F., & French, K. R. (1995). The journal of finance, 50(1), 131-155. The paper outlines the examination carried out on whether the behavior of stock prices about the size and book-to-market ratio equity reflects the earning behaviors. In line with rational pricing, high book-market equity signals persistent poor earnings while lower book to market equity predicts strong earnings. Also, stock prices forecast the reversion of earning growth seen when firms are positioned based on book-to-market equity. The paper concludes by stating that there are factors of the market, size and book-to-market equity in earnings like returns. There is a link of market and size factors in returns, but no link exists between book-to-market equity factors in earnings like returns.

Understanding the aggregate book-to-market ratio, Vuolteenaho, T. (1999). The author developed a dynamic model that links the market-to-book ratio to subsequent profitability, interest rates, and excess stock returns to enable him to get to know the general market to book ratio to connect the stock market valuation level to medium-term cash-flow fundamentals. The approach to this avoided modeling and unstable dividend process. Similar to results from earlier research, the result showed fluctuation in stock market valuation is mainly caused by risk variations although interest rate and profitability expectations also play a role in determining market prices. The model generates return and profitability forecasts.

A model of accrual measurement with implications for the evolution of the book-to-market ratio, Ryan, S. G. (1995). Journal of Accounting Research, 95-112. This paper complements recent research investigating the role of book-to-market ratios in security analysis. A model of accrual measurement is developed in the paper, and the tests were carried out to determine the evolution of the book-to-market ratio. The model extracted the intuition that book value is never timely compared to market value. As a result, the movement in market value have relatively higher variation and lower focusing power as compared with book value. The empirical test conducted on the model use show lagged market value changes to forecast the average reversion of the book-to-market variation.

Book-to-market ratios as predictors of market returns, Pontiff, J., & Schall, L. D. (1998). Journal of Financial Economics, 49(2), 141-160. Dow Jones’s book-to-market ratio forecasts market return and small firms excesses returns for the period of 1926-1994. Author further states that, the DJIA’s book-to-market ratio had information regarding future returns that were not captured by other variables such as interest yield spreads and dividend yield. This DJIA’s ratios are specific for samples earlier than 1960. On the other hand, the S&P book-to-market ratio provides some predictive ability in the post-1960 period, even though this relationship is practically weaker than the Dow Jones pre-1960 findings. The predictive ability of book-to-market ratios appears to stem from the relationship between book value and future earnings.

Book-to-market ratio and returns on the JSE, Auret, C. J., & Sinclaire, R. A. (2006). Investment Analysts Journal, 35(63), 31-38. The paper states that the book-to-market ratio is the ratio of book value of equity which is total assets less total liabilities as in the balance sheet to the market value of equity stock multiplied by the number of shares outstanding. The author talks findings made by Fama and French that there is a strong positive book-to-market ratio suggesting that companies with a higher book-to-market ratio have a greater expectation on average returns. Also, Fama and Fench in their analysis on US data for the period of 1962to 1989 showed that even though there was attention attracted to size effect, book-to-market equity has more advantages of earnings although there existed inherent uncertainty about the edges.

Book‐to‐market equity, distress risk, and stock returns, Griffin, J. M., & Lemmon, M. L. (2002). The Journal of Finance, 57(5), 2317-2336. The relationship between book‐to‐market equity, distress risk, and stock returns was examined in this paper. Among firms with the highest distress risk as proxied by Ohlson’s (1980) O‐score, the difference in returns between high and low book-to-market securities is more than twice as large as that in other firms. This large return difference cannot be explained by the three‐factor model or by differences in economic fundamentals. Companies with high distress risk exhibit the largest return reversals around earnings announcements and the book‐to‐market impact are most significant in small firms having less analyst coverage

Stock returns, dividend yield, and book-to-market ratio, Jiang, X., & Lee, B. S. (2007). Journal of Banking & Finance, 31(2), 455-475. There has been a large application of dividend model in the previous research about stock market valuation to cash flow. A lot of controversies of dividend use proxy for cash flows led to a loglinear book-to-market model’s proposal. The loglinear model also depended on the assumption that dividend yield and book-to-market ratio are both stationary, and empirical evidence for this is, at best, mixed. The assumptions led to development of another model, loglinear cointegration which explains future profitability and excess stock returns in terms of a linear combination of log book-to-market ratio and log dividend yield.

Book-to-market across firm size, exchange, and seasonality: Is there an effect?, Loughran, T. (1997). Journal of financial and quantitative analysis, 32(3), 249-268. The paper is about the report by Fama and French stating that the size and the book to market ratio involve the cross-sectional differences in stock returns in-universe of NYSE, Amex, and Nasdaq securities. In the provision of exhaustive exploration of book-to-market across the factors of the size of the company, exchange listing, and calendar seasonally, this paper reports that two characteristics of the data used drive Fama and French empirical findings. The book-to-market ratio was found to have less explanatory powers of the realized returns for period between1963-1995. The conclusion reached by the author was that book-to-market would be less important to money managers than the literature would create a belief in them.

Market-to-book Ratio

 

On the relation between the markettobook ratio, growth opportunity, and leverage ratio, Chen, L., & Zhao, X. (2006). Finance Research Letters3(4), 253-266. This literature examines the negative relation between the market-to-book ratio and leverage ratio. This paper focuses on debates about the economic interpretation of this negativity. It further shows that firms with higher market-to-book ratios face lower debt financing costs and borrow more.

Human capital indicators, business performance and markettobook ratio, Sáenz, J. (2005).. Journal of Intellectual Capital6(3), 374-384. This paper suggests a methodology to study the relationship between IC indicators and the market‐to‐book ratio (MBR) in order to show the difference between the market value of companies’ shares and their book value. In addition, it presents an exploratory application of that methodology in the field of human capital (HC) and within the Spanish banking industry. In this research, the relationships between HC, MBR and other business performance indicators are measured.

Biases and lags in book value and their effects on the ability of the book-to-market ratio to predict book return on equity, Beaver, W. H., & Ryan, S. G. (2000). Journal of accounting research38(1), 127-148. This study distinguishes two sources of variation in the book-to-market ratio (BTM) — bias and lags — with different implications for future book return on equity (ROE). It proposes 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.

Price-earnings ratio, dividend yield, and markettobook ratio to predict return on stock market: Evidence from the emerging markets, Aras, G., & Yilmaz, M. K. (2008). Journal of Global Business and Technology4(1), 18. This study examines the predictability of stock returns in the 12 emerging stock markets by using price-earnings ratio, dividend yield, and market-to-book ratio as predictive variables during the period of 1997-2003. This data is used to examine the effectiveness of the stock market.

Understanding the role of the markettobook ratio in corporate financing decisions, Chen, L., & Zhao, X. S. (2004). This study focuses on scenarios where the tradeoff theory and the costly external financing theory have drastically different or even opposite predictions about market-to-book ratio and profitability in capital structure determinants. Conclusions show that firms with higher market-to-book ratios are more likely to issue equity not because they intend to downwardly adjust their target leverage ratios, but because they face lower external financing costs. The opposite occur for firms with lower ratios.

Understanding the aggregate book-to-market ratio, Vuolteenaho, T. (1999).

In this paper,  a dynamic model that links the book-to-market ratio to subsequent profitability, interest rates, and excess stock returns is developed in order to connect the stock market valuation level to medium-term cash-flow fundamentals. Results show that fluctuating stock market valuations are primarily driven by variation in risk premia.

Conservatism correction for the markettobook ratio and Tobin’s q, McNichols, M., Rajan, M. V., & Reichelstein, S. (2014). Review of Accounting Studies19(4), 1393-1435. This literature decomposes the market-to-book ratio into two additive components: a conservatism correction factor and a future-to-book ratio. It demonstrate that the measure of Tobin’s q, obtained as the market-to-book ratio divided by the conservatism correction factor, has greater explanatory power in predicting future investments than the market-to-book ratio by itself. The study provides empirical support for these hypothesized structural properties.

Price Earning Ratio and Market to Book Ratio, Khan, M. I. (2009).  This paper studies the effects of P/E ratio and M/B ratio on stock return of listed firms with Karachi Stock Exchange in the Textile sector of Pakistan. A total of 30 major firms out of 162 in the textile sector listed with the Karachi Stock Exchange for the period of 2001-2006 were selected on the basis of their size in terms of total assets. The study reveals that the firms in an exclusive sector exhibit unique attributes that are sector specific and cannot be applied to or judged by combined analysis of the industry.

Historical markettobook ratio and corporate capital structure: Evidence from India, Mukherjee, S., & Mahakud, J. (2012). Global Business Review13(2), 339-350. This paper tries to identify the nature of historical market-to-book ratio, that is, whether it can be used as a market timing proxy or growth opportunity proxy and to find out its impact on capital structure and the adjustment speed to target capital structure.

Financing constraint, over-investment and markettobook ratio, Braouezec, Y. (2009). Finance Research Letters6(1), 13-22. In a simple symmetric information continuous time model, this study considers leverage as way to finance a fraction of the investment cost. It shows that underinvestment cannot arise while over-investment may and the room for overinvestment is negatively related with the fraction paid by equity holders. Finally, the study shows that the model formulated predicts the negative relation between the market-to-book ratio and the leverage ratio.

Portfolio strategies using EVA, earnings ratio or book-to-market: Is one best?, Leong, K., Pagani, M., & Zaima, J. K. (2009). Review of Accounting and Finance8(1), 76-86. The purpose of this study is to examine whether portfolios created by utilizing the EVAM ratio will generate higher returns than portfolios formed with EP or BM ratios.

Managerial behavior and the link between stock mispricing and corporate investments: Evidence from MarkettoBook ratio decomposition, Alzahrani, M., & Rao, R. P. (2014). Financial Review49(1), 89-116. This study examines the impact of mispricing on corporate investments and its components. By decomposing the market‐to‐book ratio into mispricing and growth components, this paper shows that corporate investments are linked to mispricing through market‐timing and catering, after controlling for growth and financial slack. Overall, this study indicates that the sensitivity of investments to mispricing is a function of the nature of mispricing, the type of investment, and the firm’s characteristics.

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