We provide a framework for identifying accounting numbers that indicate risk and expected return. Under specified accounting conditions for measuring earnings and book value, book-to-price (B/P) indicates expected returns, providing justification for B/P in asset pricing models. However, the framework also points to earnings-to-price (E/P) as a risk characteristic. Indeed, E/P, rather than B/P, is the relevant characteristic when there is no expected earnings growth, but the weight shifts to B/P with growth. Using this framework we resolve a puzzle: in contrast to previous empirical research, we find that leverage is positively associated with future returns, as predicted by theory.
Penman, Stephen, Francesco Reggiani, Scott Richardson, and Irem Tuna. "A Framework for Identifying Accounting Characteristics for Asset Pricing Models, with an Evaluation of Book-to-Price." European Financial Management 24 (2018): 488-520.
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