Negative Returns on Equity Martin A. Leibowitz Journal of Financial Statement Analysis vol. 4, no. 2 (Winter 1999):2130 The author evaluates the correlation between return on equity (ROE) and the market-to-book ratio (P/B). The relationship is not linear but has a J shape. The relationship between positive ROE and P/B is positive, but the relationship between negative ROE and P/B is inverse. The distinction between negative and positive ROE is important in valuing start-up companies.
Literature on the relationship between return on equity (ROE) and
the market-to-book ratio (P/B) indicates a positive correlation except in lower percentiles. Unlike earlier studies that do not distinguish between the correlation when ROE is negative and when it is positive, the author evaluates the relationship when this distinction is present. Three factors indicate that the relationship between ROE and P/B may be inverse if ROE is negative. First, negative earnings may be associated with positive expected future earnings if the negative earnings reflect accelerated expenses. In cases such as start-up companies, a positive P/B incorporates future expected earnings despite negative earnings in the present period. Second, negative earnings may reflect transitory items that do not influence cash flow and thus do not reduce price, again contributing to a negative correlation between P/B and ROE. Third, transitory negative earnings may influence cash flow, causing both price and ROE to decrease. The larger the negative transitory items are, the larger the increase in P/B above unity, and vice versa. Because the median P/B approximates unity, the expected correlation between ROE and P/B for these items approximates zero. Martin A. Leibowitz is at the Sy Syms School of Business at Yeshiva University. The summary was prepared by Charles F. Peake, CFA, the University of Maryland at Baltimore County. Association for Investment Management and Research
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Although previous studies have aggregated data into portfolios, the
author evaluates results for individual companies. After the author eliminates companies with negative equity and extreme observations, his sample contains 19 years of Compustat data with at least 3,000 observations for each year. The data show positive P/B for each percentile but negative ROE in the lower percentiles and a positive correlation for the entire data set. An initial plot of the data shows a nonlinear J-shaped curve, in which companies with a negative ROE show a negative relationship with P/B and companies with a positive ROE are positively related to P/B. The author next partitions the data into companies with negative ROE and those with positive ROE and presents correlation coefficients for the full set, for companies with positive ROE, and for those with negative ROE. The correlation for the full set is positive and consistent with earlier data. The partitioned data, however, show that both Spearman and Pearson correlation coefficients are consistently positive for companies with positive ROE and consistently negative for companies with negative ROE. Annual cross-section regressions test whether the distinction between negative and positive ROE contributes to explaining firm value. Simple regressions of P/B on ROE do not show statistically significant results, but the insertion of dummy variables to distinguish between positive and negative ROE results in statistically significant coefficients for each of the 19 years. The results are further improved when P/B is regressed on ranked ROE. The author concludes that a positive correlation exists between P/ B and positive ROE but a negative correlation exists between P/B and negative ROE. Distinguishing between positive and negative ROE in cross-section analysis results in significantly greater explanation of variations in P/B. Failure to distinguish between positive and negative ROE results in spurious correlations. This finding is especially important for valuing start-up companies.