Returns to Buying Earnings and Book Value: Accounting for Growth and Risk

Paths to Valuation, Asset Pricing, and Practical Investing: Can Accounting and Finance Approaches Be Reconciled?

“…In this case, a lower B/P (rather than a higher B/P) adds to the required return for a given E/P that is depressed by the growth. However, Penman and Reggiani (2010) recognize that growth, g, can also be produced by the accounting itself: Accounting that defers earnings recognition to the future produces growth. Such deferral is made under an accounting principle that responds to risk: Under uncertainty, accounting defers the recognition of earnings until uncertainty has been resolved, in effect until a low beta asset like cash or a receivable has been received.…”

“…Thus, for a given E/P, a higher B/P indicates a higher required return. The fact that B/P forecasts growth may have nothing to do with risk and return, but Penman and Reggiani (2010) indicate that the expected growth forecasted by B/P is indeed risky.…”

“…/P and B/P are in part accounting phenomena, they depend of how one accounts for earnings and book value. Accordingly, if B/P (or E/P) are to indicate risk and the required return, it might have something to do with the how accounting handles risk.ThePenman and Reggiani (2010) paper, delivered at the Jerusalem conference, points to that connection: Accounting creates earnings growth in response to risk and, if that growth is actually priced as risk in the market, a higher B/P for a given E/P will indicate that risk and the required return.The empirical results suggest so. In the panel below, firms are ranked each year, 1963-2006, on their estimated forward P/E (the inverse of the E/P) and then, within each P/E portfolio, on their B/P.…”

Accounting Anomalies, Risk and Return

“…In short, (long-run) expected earnings are at risk, with earnings outcomes over the long term determining outcomes to equity investing. And accounting operates to connect risk to growth: under uncertainty, accrual accounting defers earnings to the future and deferred earnings yields expected earnings growth, as highlighted in Penman and Reggiani (2010). Whether the risk associated with earnings growth is priced risk is an open question, of course, but that pricing is imbedded in the price deflator.…”

A framework for identifying accounting characteristics for asset pricing models, with an evaluation of book‐to‐price

“…Deferred earnings imply higher expected earnings growth but also lower current earnings and ROE, ceteris paribus, and the application of the principle under uncertainty ties the earnings deferral to risk. As an empirical matter, Penman and Reggiani (2013) show that the deferral of earnings recognition is priced in the stock market as if it indicates risk. Second, conservative accounting reduces ROE by rapid expensing of growing investment, and correspondingly induces earnings growth (Feltham & Ohlson, 1995;Zhang, 2000).…”