BE/ME and E/P work better than ME/BE or P/E in regressions

Jim Musumeci and Mark Peterson

Journal of Corporate Finance, 2011, vol. 17, issue 5, 1272-1288

Abstract: Researchers often form ratios of variables to measure firm characteristics, but which ratios create the most powerful tests? For example, if we use ratios of book value of equity (BE) and market value of equity (ME), or earnings (E) and price (P), does it matter which variable appears in the denominator? Any variable in the denominator, when close to zero, creates outliers and is less likely to produce effective tests. Our tests, using data from 1972 to 2008, indicate the choice between reciprocals often produces significantly different outcomes. While ME/BE is a more commonly used control variable than BE/ME or LN(BE/ME), we find the latter two produce better results, even if the data are trimmed to mitigate the outlier problem. Similarly, using E/P generally produces better results than P/E, and while ratios with book value of assets (BA) in the numerator work better than those with it in the denominator, the difference is less pronounced than when BE or E is part of the ratio. While the focus of our empirical findings is on growth measures, the principal applies anytime a ratio has a denominator that is frequently near zero.

Keywords: Market-to-book; Book-to-market; Price-to-earnings ratio; Test specification; Tobin's Q; Control variable (search for similar items in EconPapers)
JEL-codes: C10 C81 G30 (search for similar items in EconPapers)
Date: 2011
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Citations: View citations in EconPapers (4)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:corfin:v:17:y:2011:i:5:p:1272-1288

DOI: 10.1016/j.jcorpfin.2011.06.003

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