Abstract
Recent theoretical models (e.g., Carlson, Fisher and Giammarino, 2004) predict an association between the book-to-market (BE/ME) ratio and operating leverage in the cross-section. Consistent with these models, we find a strong positive association between BE/ME and the degree of operating leverage (DOL), and between DOL and subsequent stock returns in the cross-section. Additionally, we also find a positive association between size (i.e., market equity) and the degree of financial leverage (DFL), and a positive association between BE/ME and DFL, controlling for size. Overall, our findings provide support for a risk-based explanation for the value premium that is consistent with existing theoretical models. The evolution of systematic risk associated with firm-level investment activity, rather than financial distress, seems to be the main determinant of the value premium.
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