Why Does the Ratio of Book to Market Value of Equity Explain Cross-Section Stock Returns?

A number of papers have reported evidence that cross-section stock returns can be explained by the ration of the book value of complanies' assets to their market value. The unresolved issue, which we address here, is whether this evidence is consistent with the efficient markets hypothesis. We argue that the efficient markets model, which implies that book to market is a proxy for risk, implies also that it is a noisy proxy. This same model also presents a way to clean up this variable so that it explains stock returns more successfully. Removing the noise from book to market in this way should improve its explanatory power under the efficient markets hypothesis, while under the alternative hypothesis of irrational pricing it should cause its explanatory power to deteriorate. We present evidence in this paper that its explanatory power deteriorates.