Researchers argue the book-to-market ratio should be replaced by a related ratio, retained earnings-to-market. The book-to-market (B/M) ratio, the inverse of the price-to-book (P/B) ratio, has long been used by value investors to assess the valuation of a company.

Book value has two components. The first is contributed capital (e.g., proceeds from initial and secondary public offerings). The second is retained earnings (earnings not paid out as dividends).

Retained earnings include past earnings. They also average out inconsistencies like accruals and one-time items. The study’s authors say this makes retained earnings essentially immune to individual year accounting effects. Contributed capital, on the other hand, merely reflects the fact that investors put capital into a company. It does not provide any insights about a company’s risk, only the willingness on the part of investors to bear the risk.

Historically, book-to-market has reliably contained information about the cross section of returns (predictive power) for approximately three years. Retained earnings-to-market’s predication abilities have persisted for four years. Book-to-market’s predictive power reflects its performance during the period of June 1964 through June 1990. After July 1990, book-to-market lost its predictive power, while retained earnings-to-market maintained its predictive power. Retained earnings maintained its predictive power throughout both subperiods.

The researchers did observe “a marked drop in the correlation between book-to-market and retained earnings-to-market” starting after 1980. They further observed, “book-to-market predicted the cross section of average returns in the first half of our sample because book-to-market and retained earnings-to-market were highly correlated. In the second half of our sample period, book-to-market lost its predictive power because the change in the composition of public firms substantially reduced book-to-market’s correlation with retained earnings-to-market.”

Retained earnings-to-price also works as a good proxy for a company’s underlying earnings yield. This is because retained earnings reflect past accumulated earnings. (Earnings yield is earnings divided by price, the inverse of the price-to-earnings ratio.)

The findings were based on analysis of U.S.-listed securities for the period of 1964 through 2017.

Source: “Earnings, Retained Earnings, and Book-to-Market in the Cross Section of Expected Returns,” by Ray Ball, Joseph J. Gerakos, Juhani T. Linnainmaa and Valeri Nikolaev; Journal of Financial Economics (JFE), January 18, 2019.