Book-to-Market Equity, Financial Leverage, and the Cross-Section of Stock Returns

Iulian Obreja

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Financial Markets and Investment Strategies Corporate Finance and Governance Financial Reporting and Valuation Research

Abstract

I propose a new dynamic model of the firm that links operating leverage to both value premium and book-leverage premium in stock returns. Value firms are low-productivity firms with either high operating leverage or high financial leverage. Firms with high operating leverage maintain low book leverage ratios. When operating leverage is economically significant, both value firms and low book-leverage firms can have high equity risk premiums. In particular, value premium becomes positive while book-leverage premium becomes negative. Without operating leverage, the signs of these premiums are reversed. The model captures quantitatively several important properties of the cross-section of stock returns.

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References

1993Common risk factors in the returns on stocks and bonds 1992The Cross-Section of Expected Stock Returns 1958The Cost of Capital, Corporation Finance and the Theory of Investment 1977Determinants of corporate borrowing 2008The cost of capital, corporation finance and the theory of investment 1995What Do We Know about Capital Structure? Some Evidence from International Data 1977An equilibrium characterization of the term structure 1982Time to Build and Aggregate Fluctuations

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2019Google search and stock returns in emerging markets 2016Financial distress and equity returns: A leverage-augmented three-factor model 2018A framework for identifying accounting characteristics for asset pricing models, with an evaluation of book‐to‐price 2018Investment and the Cross‐Section of Equity Returns 2018Investment Dynamics and Earnings‐Return Properties: A Structural Approach 2015What explains the value premium? The case of adjustment costs, operating leverage and financial leverage

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