Connecting book rate of return to risk and return: the information conveyed by conservative accounting
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Connecting book rate of return to risk and return: the information conveyed by conservative accounting Stephen H. Penman 1 & Xiao-Jun Zhang 2 # Springer Science+Business Media, LLC, part of Springer Nature 2020
Abstract This paper revises the standard interpretation of the book rate of return as a measure of profitability. Rather, due to conservative accounting, the book rate of return informs about risk and the expected return to the investor. In contrast to asset pricing research, where the book rate of return is viewed as positively associated with risk and expected stock returns, the paper demonstrates the opposite: with the effect of conservative accounting, the book rate of return is negatively associated with risk and expected return. The empirical analysis indicates that the market prices equities accordingly. It also shows how the previously documented positive correlation is due to a misunderstanding of accounting and how the book rate of return enters into asset pricing in a way that is consistent with the accounting. Keywords Book rate of return . Conservative accounting . Risk and return JEL classifications G11 . G12 . M41
The authors thank Yakov Amihud, Eli Amir, Neal Arthur, Jeff Callen, Greg Clinch, Trevor Harris, Ram Ramakrishnan, Vicki Dickinson, Alfred Wagenhofer, Nir Yehuda, and seminar participants at the 7th Tel Aviv Accounting Conference, the University of Illinois, Chicago 2013 Accounting Research Conference, the UTS 2014 Accounting Conference, and Bocconi University and London Business School accounting seminars for helpful comments and suggestions. Three reviewers also made helpful comments, for which we are thankful.
* Xiao-Jun Zhang [email protected] Stephen H. Penman [email protected]
1
Graduate School of Business, Columbia University, New York City, NY, USA
2
Haas School of Business of Business, University of California, Berkeley, Berkeley, CA, USA
S. H. Penman, X.-J. Zhang
1 Introduction In financial analysis, the book rate of return is typically viewed as a measure of profitability to be compared to the required return—the hurdle rate—to evaluate the success of an investment. That is appropriate under the economic concept of a rate of return that separates stocks and flows—capital from income—such that payoffs from investment are compared to the amount of investment that yields the payoff. However, GAAP and IFRS accounting mixes the two: under so-called conservative accounting, some investment reduces the payoff from investment (earnings, in the numerator of the rate of return) and is excluded from the investment base (net assets in the denominator). That requires a reinterpretation of the measure, which this paper supplies: with the effects of conservative accounting, the book rate of return conveys information about the risk to investing. Rather than a profitability measure to compare with the required return, book rate of return conveys information about the required return. We take the insights in the paper to asset pricing research, where book return on equity,
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