Growth and Risk in Market Pricing

Historical cost accounting deals with uncertainty by deferring the recognition of earnings until the uncertainty has largely been resolved. Such accounting affects both earnings and book value and produces expected earnings growth deemed to be at risk. In terms used in asset pricing, earnings are not recognized until the firm has a low beta asset, typically cash or a near-cash receivable that are booked upon ''realization'' of outcomes, usually with a sale. It is unclear, however, whether such accounting practices align with the way that risk is priced in the market.

In a recent article titled Returns to Buying Earnings and Book Value: Accounting for Growth and Risk, winner of the prestigious Roger F. Murray Prize (The Q Group) and forthcoming on the Review of Accounting Studies (doi: 10.1007/s11142-013-9226-y), Francesco Reggiani, an assistant professor at Bocconi University's Department of Accounting, and his coauthor Stephen Penman (Columbia Business School) shed some light on the issue by providing an accounting rationale for the well-documented book-to-price effect: for a given earnings-to-price (E/P), a higher book-to-price (B/P) indicates higher expected growth that is priced as risky. This suggests a revision of the notion of ''value'' versus ''growth'' investing. In that dichotomy, ''growth'' (associated with a low book-to-price) is deemed to be low risk, yielding lower average returns. The paper shows that it is a high B/P rather than a low B/P that indicates the risky growth. The authors develop this intuition by first reviewing how earnings-to-price and book-to-price relate to expected returns in the literature, then by introducing accounting principles in the context of a model that relates earnings and book value to price, which provides the blueprint for a thorough econometric analysis.

Results confirm earlier evidence that earnings yields (earnings-to-price) predict stock returns, which is consistent with the notion that expected earnings are at risk and price discounts for that risk. However, investors not only buy short-term earnings but also subsequent earnings (growth), and both are presumably at risk. Book-to-price in fact indicates expected returns associated with expected earnings growth: for a given earnings yield, book-to-price yields additional expected returns in the data, and those additional returns can be explained by book-to-price indicating risky growth. The so-called book-to-price effect in stock returns can thus be explained as rational pricing, but in a way that differs from the typical characterization in ''value'' versus ''growth'' investing, where low book-to-price indicates ''growth'' and that growth is associated with lower returns. Rather, high book-to-price indicates growth and yields higher returns (for a given earnings yield), consistent with the notion that growth is risky and is priced as such. Ultimately, since accounting defers earnings recognition to the future under uncertainty and defers relatively more earnings to the long-term future when outcomes are particularly risky, earnings deferred to the long run, relative to earnings in the short run, indicates the risk a firm faces.