The book-to-market ratio, optimism and valuation

There is no agreement as to why the book-to-market (BTM) ratio is positively related to future stock return. Behavioural finance maintains that low BTM stocks have optimistic expectations embedded in their prices and the prices of high BTM stocks are less optimistic. An alternative view is that risk is increasing in the BTM ratio. This paper confirms that the BTM effect is related to earnings disappointments. However, it is posited that the association of the BTM ratio with subsequent return stems from its ability to predict the price reaction to an earnings disappointment rather than its predictive ability for earnings disappointments per se. Specifically, accounting valuation models suggest that the price of low BTM stocks is sensitive to earnings disappointments while that of high BTM stocks is not. Evidence consistent with this prediction is provided. Fundamental valuation reasons and not differential optimism underlie the BTM ratio’s ability to predict return.