Equity Book-to-Market Ratios Above One and Macroeconomic Risk

Equity book-to-market ratios (BTM) should not exceed one if a firm’s return on equity exceeds its cost of capital or it employs conservative accounting. Yet, BTM is above one for many firms. We address whether BTM above one reflects macroeconomic risk, which could explain this apparent incongruity. We find BTM above one generates larger hedge returns than BTM below one, but HML—the BTM-based return prediction factor—does not explain the returns for BTM above one. We also find that hedge returns for BTM above one are concentrated in recession years and likely reflect risk rather than mispricing. In addition, we find BTM above one reflects potentially overstated equity book values, but only in non-recession years. In contrast, high BTM below one does not generate hedge returns and reflects potentially overstated equity book values in recession and non-recession years. Together, our findings reveal that BTM above one reflects macroeconomic risk, which means that BTM above one has implications for risk assessment, return prediction, and asset under-impairment identification. Our study calls into question using HML as a return prediction factor for BTM above one and using BTM as a generic measure of conservative accounting or as the key indicator of overstated asset book values.