Conservatism Correction for the Market-To-Book Ratio and Tobin’s q

We decompose the market-to-book ratio into two additive components: a conservatism correction factor and a future-to-book ratio. The conservatism correction factor exceeds the benchmark value of one whenever the accounting for past transactions has been subject to an (unconditional) conservatism bias. The observed history of a firm’s past investments allows us to calculate the magnitude of its conservatism correction factor, resulting in an average value that is about two-thirds of the overall market-to-book ratio. We demonstrate that our measure of Tobin’s q, obtained as the market-to-book ratio divided by the conservatism correction factor, has greater explanatory power in predicting future investments than the market-to-book ratio by itself. Our model analysis derives a number of structural properties of the conservatism correction factor, including its sensitivity to growth in past investments, the percentage of investments in intangibles, and the firm’s cost of capital. We provide empirical support for these hypothesized structural properties. JEL-Code: M410, L250, G110. Maureen McNichols Graduate School of Business Stanford University Stanford CA / USA [email protected] Madhav V. Rajan Graduate School of Business Stanford University Stanford CA / USA [email protected] Stefan Reichelstein Graduate School of Business Stanford University Stanford CA / USA [email protected] December 18, 2013 We thank William Beaver, James Ohlson, Alexander Nezlobin, Stephen Penman (editor), Stephen Ryan, two anonymous reviewers, and workshop participants at Berkeley, Copenhagen (Interdisciplinary Workshop), Harvard, ISB (Hyderabad), Michigan, Muenchen (LMU), Northwestern, NYU, WHU, and Stanford for their valuable comments. We also acknowledge the excellent research assistance of Maria Correia, Moritz Hiemann, Eric So, Yanruo Wang, and Anastasia Zakolyukina.