Decomposing the Book-to-Price Effect: Leverage and Stock Returns:
Abstract: The starting point for this thesis is a decomposition of book-to-price (B/P) into an enterprise-book-to-price component (that pertains to the firms operations and supposedly reflects operating risk) and a leverage component (assumed to capture financial risk), laid out by Penman et al (2007). Using Swedish data, we show that the leverage component of B/P is negatively associated with future stock returns, conditional upon enterprise-book-to-price. This result is in line with the findings of Penman et al (2007) and contradicts the basic finance tenet of a return premium to leverage. With the hypothesis that the puzzling results could be explained by omitted operating risk factors negatively correlated with leverage, we include unlevered beta and variability in return on net operating assets as alternative operating risk proxies. This does not alter the negative relationship, but our results imply that the B/P constituents fail to adequately explain operating and financial risk factors in returns. We propose an alternative model of expected return, and our results point at a twofold leverage effect that explains the puzzling irregularity and needs to be taken into consideration when examining the association between leverage and stock returns.
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