UNDERSTANDING SIZE AND THE BOOK‐TO‐MARKET RATIO: AN EMPIRICAL EXPLORATION OF BERK'S CRITIQUE

Xinting Fan and Ming Liu

Journal of Financial Research, 2005, vol. 28, issue 4, 503-518

Abstract: Because they are scaled by price, the ability of size (i.e., the market capitalization of a firm) and the book‐to‐market equity ratio to determine expected returns may, according to Berk (1995), reflect only a simultaneity bias. The two‐stage least squares approach is used to control for this bias and to investigate the economic meanings of these variables. We discover that size and the book‐to‐market ratio contain distinct and significant components of financial distress, growth options, the momentum effect, liquidity, and firm characteristics. Our findings support Berk in his contention that that size and the book‐to‐market ratio reflect a combination of different economic mechanisms that are misspecified in the expected return process.

Date: 2005
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