Disentangling the Enterprise Book-to-Price and Leverage Effects in Stock Returns - A Commentary on Penman, Richardson and Tuna (2007)

In contrast to the theory based propositions in Modigliani and Miller (1958; 1963) of a positive relationship between the cost of equity capital and financial leverage, claims of a negative empirical relationship between stock returns and leverage have been made in the article 'The Book-to-Price Effect in Stock Returns: Accounting for Leverage' (Penman, Richardsson and Tuna, 2007). This commentary contributes through some additional modeling and tests of the association between stock returns and leverage, explicitly taking account of the twofold effect of leverage on equity returns – a risk enhancing, compounding operating risk effect, and a negative interest cost effect. Given that the equity book-to-price ratio (B/P) constitutes a valid measure of equity investment risk, Penman et al proposed that the enterprise book-to-price ratio (NOA/PNOA) should reflect the firm´s operating risk. In line with this idea, stock returns have been regressed on the enterprise book-to-price ratio, the compounding operating risk effect and financial leverage in our tests. With a U.S. sample from the period 1962–2006 (subsuming the sample used in Penman et al, 2007), our results show – in line with Modigliani and Miller (1958; 1963) − that there is a robust positive association between stock returns and this compounding risk effect of leverage. We also find a robust negative association between stock returns and leverage itself, presumably reflecting the interest cost of debt. Regressions including the difference between the enterprise book-to-price and the equity book-to-price, show that the comprehensive effect of leverage (as implied by the equity book-to-price ratio) is positive for the sample partition where the enterprise-book-to-price is less than 1. Our modeling and empirical results indicate that the negative relationship between stock returns and leverage found by Penman et al, does not appropriately reflect the risk effect of leverage but might just be driven by the negative interest cost effect of debt