James Davis

Is There Still Value in the Book-to-Market Ratio?

Conclusions

There is no evidence of BtM becoming irrelevant for identifying value stocks. Compared to popular alternatives, BtM is at least as good at producing dispersion in average returns. This ability has not declined in recent years. The changes in the composition of the US economy during the past several years have not eliminated the strong cross-sectional relation between BtM and realized returns.

There is one advantage of BtM relative to its peers that should be mentioned. Since book value is a "stock" variable, while earnings, cash flow and sales are "flow" variables, there is a tendency for BtM rankings to be somewhat more stable over time than the rankings based on the other three variables. This reduces portfolio turnover for strategies that are based on BtM rankings. So, in addition to providing at least as much return dispersion as its competitors, BtM may also reduce the number of transactions that are triggered by stocks moving in and out of the portfolio's buy range. This can be especially important for taxable investors.

The helpful comments of David G. Booth, Andrew Cain, Truman A. Clark, Eugene F. Fama, Kenneth R. French, Mark R. Gochnour, Eduardo A. Repetto, Rex A. Sinquefield, and Weston J. Wellington are gratefully acknowledged.

¹ The sample each year is restricted to firms that have positive values for sales, book value, earnings, and cash flow. This is done so that each firm can be included in all four rankings. Market values are taken from CRSP, and accounting variables are taken from Compustat.

² It can be argued that ranking variables should be judged by average absolute return differences rather than average return differences. Using absolute return differences does not change any of the conclusions of this study. Since 1963, BtM has produced the largest absolute return difference in twelve of the thirty-seven years. Sales/price, earnings/price and cash flow/price produced the largest absolute dispersion in eleven, eight, and six years, respectively.

January 2001