Investments, tenth edition

 Figure 13.4 

The book-to-market ratio reflects past growth, but not future 

growth prospects. B/M tends to fall with income growth experienced at the  end  

of a 5-year period, but actually increases slightly with future income growth rates.   

 Source: L.K.C. Chan, J. Karceski, and J. Lakonishok, “The Level and Persistence of Growth Rates,”  Journal 

of Finance  58 (April 2003), pp. 643–84. Used with permission of John Wiley and Sons, via Copyright Clear-

ance Center. 

Book/Market Ratio

−0.4

−0.2

0

0.2

0.4

0.6

0.8

1.0

1.2

1

2

3

4

5

6

7

8

9

10

Growth Rate Decile

Median growth rate

Beginning B/M

Ending B/M

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P A R T   I I I

  Equilibrium in Capital Markets

 But B/M at the  beginning  of a 5-year period shows little or even a positive association 

with subsequent growth (the solid colored line), implying that market capitalization today 

is  inversely  related to growth prospects. In other words, the firms with lower B/M (glamour 

firms) experience no better or even worse average future income growth than other firms. 

The implication is that the market ignores evidence that past growth cannot be extrapolated 

far into the future. Book-to-market may reflect past growth better than future growth, con-

sistent with extrapolation error. 

 

More direct evidence supporting extrapolation error is provided by La Porta, 

Lakonishok, Shleifer, and Vishny,  

27

   who examine stock price performance when actual 

earnings are released to the public. Firms are classified as growth versus value stocks, and 

the stock price performance at earnings announcements for 4 years following the classifi-

cation date is then examined.  Figure 13.5  demonstrates that growth stocks underperform 

value stocks surrounding these announcements. We conclude that when news of actual 

earnings is released to the public, the market is relatively disappointed in stocks it has been 

pricing as growth firms.