
A market-to-book formula for equity strategies
A new proxy formula for equity market-to-book ratios suggests that (the logarithm of) such a ratio is equal to the discounted expected value of (i) differences between return on equity and market returns and (ii) the net value added from share issuance or repurchases. A firm with a higher market-to-book ratio must have lower future returns, higher return on equity, or more valuable growth or repurchase opportunities. One can cleanly decompose return forecasts into forecasts of future profitability, investment, and the market-to-book ratio at any horizon. Empirical evidence confirms that market-to-book ratios predict returns in the long run, but only to the extent that the ratio itself is not affected by profitability and investment. Indeed, profitability and investment value-added jointly explain about 60% of variations in market-to-book ratio and – hence – should be taken into consideration for investment strategies based on valuation ratios. This broader view helps to forecast returns on value stocks versus growth stocks.