Implied returns, costly reversibility and the value premium

Abstract

The countercyclical price of risk is revealed through declining earnings, dividends, equity book and equity market values, short-run earnings expectations and increasing market returns (k), risk premiums (MRP) and book-to-market (BM) with contractions. Consistent with costly reversibility, high BM firms with more fixed assets are less profitable and dispose of more fixed assets during contractions than low BM firms. Support for costly reversibility looking at k and MRP is found when firms are ranked according to fixed-asset-to-total-assets (FATA) but not BM. Low BM firms with generally lower k and MRP experience greater increases in k and MRP than high BM firms during contractions whereas high FATA firms with generally lower k and MRP experience greater increases in k and MRP than low FATA firms during contractions. With expected earnings growth increasing for high BM firms, BM as a measure to distinguish between growth and value is challenged. Thus, while support is provided for costly reversibility, it is limited in explaining the value premium.