Value Relevance of Firm Size Proxies in Predicting Stock Returns: Market Capitalization or Total Book Assets?

Abstract

This paper examines the value relevance of three firm size proxy variables, market value (MV), total book assets (TBA), and market value of total book assets (MVTA), in asset pricing models. The findings support MV providing marginally higher relative value relevance in predicting future stock returns, but also reveal that an increase in explanatory power of approximately 25 percent is obtained when both MV and TBA are included in the same one-year-ahead predictive returns model at the firm-level. Moreover, the findings at the portfolio-level show average annual size-adjusted returns increase by 12.7 percent or by 5.4 percent using the Fama and French three-factor model augmented with momentum, when going from the lowest to the highest TBA decile portfolio while controlling for MV. These abnormal returns are not found to be related to standard measures of stock portfolio risk or to the accruals and asset growth anomalies. However, some evidence points towards investors not fully incorporating the present value of projects into stock prices due to the timing of accounting earnings. Therefore, using TBA will improve stock return prediction and the observance of abnormal stock returns in this study from using information on the levels of TBA indicates a potential for increasing market efficiency. Finally, I show that institutional investors can potentially satisfy their requirement to avoid small MV firms, but still obtain the significantly high raw and abnormal returns associated with small firms if they are also high TBA firms.