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

Authors


  • We thank Jonathan Berk for encouraging us to take on this research project and for his comments. We thank William T. Moore (the editor), an anonymous referee, Larry Kryzanowski, and participants at the 2002 Financial Management Association annual conference at San Antonio, Texas for useful suggestions. All errors are ours. The research described herein was partially supported by the Research Grants Council of the Hong Kong Special Administrative Region, China.

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.

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