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28 Asset Valuation

Market-to-Book Ratios and Positive and


Negative Returns on Equity
Martin A. Leibowitz
Journal of Financial Statement Analysis
vol. 4, no. 2 (Winter 1999):2130
The author evaluates the correlation between return on
equity (ROE) and the market-to-book ratio (P/B). The
relationship is not linear but has a J shape. The relationship between positive ROE and P/B is positive, but
the relationship between negative ROE and P/B is
inverse. The distinction between negative and positive
ROE is important in valuing start-up companies.

Literature on the relationship between return on equity (ROE) and


the market-to-book ratio (P/B) indicates a positive correlation
except in lower percentiles. Unlike earlier studies that do not
distinguish between the correlation when ROE is negative and
when it is positive, the author evaluates the relationship when this
distinction is present.
Three factors indicate that the relationship between ROE and P/B
may be inverse if ROE is negative. First, negative earnings may be
associated with positive expected future earnings if the negative
earnings reflect accelerated expenses. In cases such as start-up
companies, a positive P/B incorporates future expected earnings
despite negative earnings in the present period. Second, negative
earnings may reflect transitory items that do not influence cash
flow and thus do not reduce price, again contributing to a negative
correlation between P/B and ROE. Third, transitory negative earnings may influence cash flow, causing both price and ROE to
decrease. The larger the negative transitory items are, the larger
the increase in P/B above unity, and vice versa. Because the median
P/B approximates unity, the expected correlation between ROE
and P/B for these items approximates zero.
Martin A. Leibowitz is at the Sy Syms School of Business at Yeshiva
University. The summary was prepared by Charles F. Peake, CFA, the
University of Maryland at Baltimore County.
Association for Investment Management and Research

Asset Valuation 29

Although previous studies have aggregated data into portfolios, the


author evaluates results for individual companies. After the author
eliminates companies with negative equity and extreme observations, his sample contains 19 years of Compustat data with at least
3,000 observations for each year. The data show positive P/B for
each percentile but negative ROE in the lower percentiles and a
positive correlation for the entire data set. An initial plot of the data
shows a nonlinear J-shaped curve, in which companies with a
negative ROE show a negative relationship with P/B and companies with a positive ROE are positively related to P/B.
The author next partitions the data into companies with negative
ROE and those with positive ROE and presents correlation coefficients for the full set, for companies with positive ROE, and for
those with negative ROE. The correlation for the full set is positive
and consistent with earlier data. The partitioned data, however,
show that both Spearman and Pearson correlation coefficients are
consistently positive for companies with positive ROE and consistently negative for companies with negative ROE.
Annual cross-section regressions test whether the distinction
between negative and positive ROE contributes to explaining firm
value. Simple regressions of P/B on ROE do not show statistically
significant results, but the insertion of dummy variables to distinguish between positive and negative ROE results in statistically
significant coefficients for each of the 19 years. The results are
further improved when P/B is regressed on ranked ROE.
The author concludes that a positive correlation exists between P/
B and positive ROE but a negative correlation exists between P/B
and negative ROE. Distinguishing between positive and negative
ROE in cross-section analysis results in significantly greater explanation of variations in P/B. Failure to distinguish between positive
and negative ROE results in spurious correlations. This finding is
especially important for valuing start-up companies.

The CFA Digest Summer 1999