Japan and the World Economy 10 (1998) 467485

The usefulness of earnings versus book value for predicting

stock returns and cross corporate ownership in Japan
Kee Hong Bae, Jeong-Bon Kim1,*
Department of Accountancy, The Hong Kong Polytechnic University, Hung Hom, Kowloon, Hong Kong
Received 30 September 1997; received in revised form 31 January 1998; accepted 31 March 1998

Abstract
Using a sample of Japanese rms, this paper evaluates the usefulness of the two fundamental
products of an accrual accounting system, namely accrual earnings and book value of equity for
predicting stock returns. Our analysis shows that both earnings and book value for Japanese rms
have the ability to provide for protable trading strategies or improved portfolio decisions, and that
relative to the trading strategy based on earnings or book value alone, the trading strategy based on
a combination of both earnings and book value generates substantially higher returns for all cases.
This suggests that book value (or earnings) captures certain aspects of equity values that are not
captured by earnings (book value). Our multivariate regression results further indicate that the
predictive ability of earnings is dominated by that of book value. Finally, it is found that the
predictive ability of book value is sensitive to the degree of cross corporate ownership, while it is
insensitive to the degree of real estate holding. # 1998 Elsevier Science B.V.
JEL classication: G12
Keywords: Earnings; Book value; Predictive ability; Market inefciency; Cross corporate
ownership; Real estate holdings

1.

Introduction

The Japanese equity market has been well characterized by the high valuation level
relative to other developed markets, such as the US (Aron, 1989; French and Poterba, 1991;
Hall et al., 1994; Choi, 1995). In particular, valuation relatives such as price-to-earnings
ratios and price-to-book ratios for Japanese stocks were very high during the 1980s and
* Corresponding author. Tel.: 00 852 2766 7080; fax: 00 852 2330 9845; e-mail: acjbkim@polyu.edu.hk
1
Bae is at City University of Hong Kong. Kim is at The Hong Kong Polytechnic University, and is currently
on leave from Concordia University (Montreal, Canada).
0922-1425/98/$19.00 # 1998 Elsevier Science B.V. All rights reserved.
PII S0922-1425(98)00029-2

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K.H. Bae, J.-B. Kim / Japan and the World Economy 10 (1998) 467485

early 1990s by international standards. Using consolidated accounting numbers, for

example, Hall et al. (1994) compare price-to-earnings ratios for the US and Japanese
stocks, and report that during the 19861991 period, the median ratio for Japanese stocks
was consistently over 40 while it has ranged between 11 and 16 for the US stocks. A similar
disparity between the two markets was observed for price-to-book ratios.2
Intuitively, price-to-earnings ratios (P/E) and price-to-book ratios (P/B) could be viewed
as a multiple that the market attaches to earnings and book value, respectively, in
determining market prices. On the one hand, high P/E (P/B) for Japanese stocks could
be observed when they are overvalued relative to the underlying value implied by earnings
(book value), an argument consistent with market inefciency (or `stock market bubble').
To the extent that Japanese stocks are mispriced at a certain point of time relative to
intrinsic values implied by accounting fundamentals, such as earnings and book value and
that market prices gravitate slowly towards the intrinsic values, earnings and book value
would be useful for predicting the behavior of future stock prices or returns, and thus, one
would be able to construct protable trading strategies based on earnings and book value.3
On the other hand, high P/E (P/B) could also be observed when reported accounting
earnings (book value) understate a rm's fundamental value, an indication of the poor
quality of reported accounting numbers. In such a case, the predictive ability of earnings
and book value would be limited.
Over the last three decades, numerous studies in the US accounting literature have
examined contemporaneous associations between stock prices or returns and accounting
numbers to draw inference about the information content of alternative accounting
measures.4 This line of research, often called the informational perspective of accounting,
typically assumes that currently observed prices are an efcient summary of information,
and thus, that one cannot construct protable trading strategies using information contained in published accounting reports. Several studies have examined the role of reported
accounting numbers in the Japanese equity market. Adopting the informational perspectives of accounting, Sakakibara et al. (1988) and Darrough and Harris (1991) examine
market reactions to earnings news and/or management forecasts in the Japanese equity
market. Both studies provide evidence supporting that reported earnings and/or management forecasts are value-relevant. Chan et al. (1991) examine contemporaneous relations
between excess returns on common stocks and fundamental variables for Japanese rms at
the portfolio level. They document that fundamental variables, such as earning yields,
book-to-price ratios and rm size, have the ability to explain excess stock returns in Japan.

2
Previous research suggests that the huge disparity in the valuation relatives observed between the US and
Japan could arise from several factors including: (1) fundamental factors, such as the relatively low interest rate
or cost of capital in Japan (Ando and Auerbach, 1988; and Frankel, 1991; Frankel, 1993), the relatively high land
value in Japan (Frankel, 1991; Frankel, 1993), and the exchange rate movement (Choi, 1995); (2) institutional
factors, such as high ownership concentration and/or cross corporate ownership in Japan (Bildersee et al., 1990;
and French and Poterba, 1991); and (3) differences in accounting standards, such as conservative accounting
practices in Japan (French and Poterba, 1991; and Cheung et al., 1998).
3
In such a case earnings and book value are likely to be associated with future stock prices or returns, but not
with current stock prices or returns.
4
See Bernard (1989) and Lev (1989) for an extensive review of the early literature.

K.H. Bae, J.-B. Kim / Japan and the World Economy 10 (1998) 467485

469

In contrast, Hall et al. (1994) examine contemporaneous associations between stock returns
and accounting earnings in Japan over various windows, and conclude that ``Japanese stock
prices were largely unrelated to fundamental values based on accounting measures for
most of the 1980s'' (p. 49). As such, evidence on the valuation relevance of reported
accounting numbers in Japan is mixed at best. Furthermore, the results of the aforementioned studies using Japanese data should be interpreted cautiously, in particular, because
insignicant (contemporaneous) associations observed between current prices and
accounting fundamentals could be a result of either market inefciency or the low quality
of reported accounting numbers and/or both.
Given the above background, this paper aims to provide empirical evidence on the
valuation relevance of earnings and book value in Japan, adopting the approach which does
not require the notion of market efciency. In particular, we rst examine the relative
usefulness of accrual earnings (E) and book value of equity (B) for predicting stock returns,
using the measurement perspective of accounting. Unlike Hall et al. (1994) who examine
contemporaneous associations between stock prices or returns and each accounting value
measure, our analysis focuses on the ability of accounting earnings and book value to
provide for improved portfolio decisions or protable trading strategies. To do so, we
construct two simple, but implementable, trading strategies that involve zero net-investment hedge portfolios: (1) the E/P strategy under which portfolios are constructed based on
the ratio of accrual earnings to market value of equity (earnings-to-price ratio: E/P); and (2)
the B/P strategy under which portfolios are constructed based on the ratio of book value of
equity to market value of equity (book-to-price ratio: B/P). We then observe buy-and-hold
returns up to 3 years subsequent to portfolio formation. The relative usefulness of earnings
vs. book value as an indicator of rm value is evaluated by comparing the protability of
the two strategies.5 If the Japanese market is inefcient in that stocks are overpriced
relative to their intrinsic values implied by earnings and book value, thus leading to
unusually high P/E and/or P/B, one may effectively construct protable trading strategies
using fundamental variables, such as earnings and book value. Our rst objective is to
provide empirical evidence on this issue.
Second, we examine the incremental usefulness of earnings vs. book value to obtain
further insight into the question of whether the two distinct accounting value measures
capture the same aspect of rm value or not. To do so, we also construct trading strategies
based on a combination of E/P and B/P (hereafter, the combined strategy). If, for example,
earnings and book value capture different aspects of rm value, one could expect that the
combined strategy (which incorporates information contained in both indicators of rm
value) yields higher returns than does the strategy based on earnings or book value alone
(Cheung et al., 1997). Several researchers argue that information contained in balance
sheets, such as book value of equity or net assets and land values, are more value-relevant
for Japanese stocks than information contained in income statements, such as earnings
(e.g., Choi et al., 1983; Wakasugi, 1988). Further, Chan et al. (1991), Bildersee et al. (1990)

5
As noted by Lev (1989), the criterion used in this study for evaluating the relative usefulness of accounting
earnings and book value is more consistent with the real-life notion of information quality as well as the FASB's
concept of information usefulness.

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K.H. Bae, J.-B. Kim / Japan and the World Economy 10 (1998) 467485

and Bildersee et al. (1993) suggest that Japanese investors tend to rely more on book value
or net assets than on earnings or cash ows.6 Our second objective is to provide further
evidence on the issue by focusing on the incremental usefulness of book value (or earnings)
over earnings (or book value) for predicting stock returns.
Finally, we examine whether the predictive ability of earnings vs. book value is
differentially affected by the degree of cross corporate ownership (through investment in equity shares of afliated rms) and the degree of real estate holding
relative to total assets. The cross corporate ownership among afliated rms may have
important implications for the valuation relevance of earnings and book value.
Under generally accepted accounting principles (GAAPs) in Japan, equity investments
by a rm into other rms are valued at the original cost unless it is higher than the
associated market value. Similarly, values of real estate assets, such as land and building,
are recorded at their original acquisition costs with no supplemental information provided
for their current costs (Choi and Mueller, 1992). Given the prevalence of cross ownership and the high market value of real estates in Japan, it is interesting to examine
whether, and how, these two rm-specic variables distort the predictive ability of earnings
and book value.
Briey, our results show that both earnings and book value have the ability to provide for
protable trading strategies and that trading strategies based on a combination of both
earnings and book value yield substantially higher returns than those based on earnings or
book value alone. This suggests that earnings and book value are not only individually but
also incrementally useful for predicting future stock returns in Japan. Multivariate
regression analysis shows, however, that the predictive ability of earnings appears to
be dominated by that of book value. Further, it is found that the predictive ability of book
value is sensitive to the degree of cross corporate ownership, while it is insensitive to the
degree of real estate holding.
The rest of the paper is structured as follows: In Section 2, we describe sample and data
sources and provide empirical denitions of research variables used, along with their
summary statistics. In Section 3, we explain test procedures and present empirical results.
The Section 4 concludes the paper.
2.

Data description and variables definitions

The initial list of sample for this study consists of all non-nancial and non-utility rms
that are included in the 1994 PACAP database for Japan complied by the Pacic-Basic
Capital Market (PACAP) Research Center at University of Rhode Island. This database
contains stock market data, including daily and monthly returns, and nancial statement
data for the period from July 1975 to September 1993. We exclude rms in the nancial
service industry because economic meanings of accounting numbers used in this study may
differ between nancial and non-nancial rms. We exclude utility rms to avoid potential
confounding effects of government regulations on our results.
6

Bildersee et al. (1990) report that E/P is more volatile for Japanese stocks than for the US stocks

K.H. Bae, J.-B. Kim / Japan and the World Economy 10 (1998) 467485

471

Our sample period for constructing trading strategies covers from July 1976 to
September 1990.7 We evaluate the performance of various trading strategies by observing
monthly buy-and-hold returns (BHRs) for various holding periods up to 36 months after the
rst trading day of October in each year,8 thus making 1990 the last year for portfolio
formation. This October starting date for the BHR calculation is chosen to ensure that
information contained in annual nancial statements is publicly available to market
participants before observing BHRs to various trading strategies.9 For this sample period,
we identify 21 901 rm/year observations which have monthly return data for at least 1
year subsequent to portfolio formation and all the data required to calculate empirical
measures of the following variables10:
1. Firm size (ln P): The natural log of the market value of equity (i.e., price per common
share times the number of common shares outstanding) at the end of the sixth month
after scal-year end.
2. Earnings-to-price ratio (E/P): Operating income (which is similar to earnings
before extraordinary items and discontinued operations under US GAAPs) for fiscal
year t divided by the market value of equity at the end of the sixth month after
fiscal-year end.
3. Book-to-price ratio (B/P): Book value of equity at the end of fiscal year t divided by the
market value of equity at the end of the sixth month after fiscal-year end.
4. Degree of cross corporate ownership among affiliated firms (CRH): The dollar amount
of investments by a firm into affiliated firms divided by book value of net assets for the
firm.
5. Degree of real estate holding (REH): Book value of land and building divided by total
assets.
Panel A of Table 1 reports descriptive statistics for the above five variables as well as 12month market-adjusted returns (MAR1) and Beta. MAR1 represents compounded monthly
buy-and-hold returns for the 12-month period beginning in October of year t1 in excess of
the Tokyo Stock Exchange (TSE) value-weighted index returns for the same period. Beta is
calculated by estimating the slope parameter of market model using past 5-year monthly
observations ending fiscal-year ends, and thus, the number of observations used for Beta
calculation is smaller than that for other variables. As shown in the table, means (medians)
of E/P and B/P for firms with positive earnings and positive book value, denoted by E()/P
and B()/P, are 0.10 (0.07) and 0.44 (0.41), respectively. Both mean and median for Beta is

7
The first 1 year from the data period is dropped because that book value is observed at the end of fiscal year.
The last 3 years are sacrificed to observe 3-year buy and hold returns after portfolio formation dates.
8
Fama and French (1992) use the first trading day of July as the portfolio formation date. Note, however, that
in Japan, the fiscal-year end for most firms is March 31, while in the US, it is December 31. Thus, the first
trading day of October for firms with the March 31 fiscal-year end is equivalent to the first trading day of July
for the December 31 firms.
9
Note that for similar reasons, Fama and French (1992) also use the July stating date for calculating average
(1-year ahead) returns.
10
Out of 21 901, we identify 20 412 firm-year observations which have positive earnings and book value.

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K.H. Bae, J.-B. Kim / Japan and the World Economy 10 (1998) 467485

Table 1
Summary statistics
Panel A: Descriptive statistics
MAR1 a
E()/P c
B()/P b
Size d
Beta e
CRH f
REH g

Mean

Median

Std. dev.

Maximum

Minimum

No. of obs.

0.01
0.10
0.44
10.41
1.04
0.30
0.12

0.07
0.07
0.41
10.30
1.02
0.19
0.10

0.43
0.09
0.24
1.52
0.51
1.13
0.08

10.78
3.49
1.72
17.61
4.34
13.75
0.81

1.09
0.00
0.00
6.15
2.25
1.55
0.00

20 412
20 412
20 412
20 412
14 469
19 769
19 378

Panel B: Pearson correlation matrix

MAR1 a
B()/P b
E()/P c
Size d
Beta e
CRH f
REH g

MAR1 a

B()/P b

E()/P c

Size d

Beta e

CRH f

REH g

1.00
0.07 h
0.04 h
0.10 h
0.00
0.00
0.00

1.00
0.38 h
0.31 h
0.10 h
0.04 h
0.02 h

1.00
0.30 h
0.04 h
0.06 h
0.10 h

1.00
0.22 h
0.00
0.01

1.00
0.02 h
0.07 h

1.00
0.05 h

1.00

Denotes compounded monthly buy-and-hold returns for the 12-month period beginning in October of year t1
in excess of the Tokyo Stock Exchange value-weighted index returns fir the same period.
b
Represents book-to-price ratio for the firms with positive book value.
c
Represents earnings-to-price ratio for the firms with positive earnings.
d
Represents the natural log of market capitalization as of the end of the sixth month after fiscal-year end.
e
Represents market risk estimated using past 5-year monthly returns ending fiscal-year end.
f
Denotes the degree of corporate cross ownership among affiliated firms that is defined as book value of
investment by a firm into other firms divided by book value of its net assets.
g
Denotes the degree of real estate holding that is defined as the book value of a firm's real estate assets (land and
building) divided by book value of total assets.
h
Indicates the 1% level of significance.

close to its theoretical value for market portfolio (1.00). The mean of CRH is 0.30,
indicating that Japanese firms, on average, invest 30% of its net assets into other affiliated
firms. The mean is greater than its median (0.19) with relatively high standard deviation
(1.13) and range, indicating that the CRH distribution is not bell-shaped. It should be noted
that as will be explained later, the CRH variable (as well as the REH variable) is used in this
study only for the purpose of partitioning the sample into two groups (above median and
below-median groups). The mean and median of REH are 0.12 and 0.10, respectively, with
relatively low standard deviation of 0.08.
Panel B of Table 1 reports the correlation matrix. Consistent with our expectation,
MAR1 is signicantly (positively) correlated with B()/P and E()/P, while it is
signicantly (negatively) correlated with rm size. There is little correlation between
MAR1 and market beta. Note that the correlation between E()/P and B()/P is the
highest, and that both variables are highly (negatively) correlated with rm size.

K.H. Bae, J.-B. Kim / Japan and the World Economy 10 (1998) 467485

3.

473

Test procedures and empirical results

3.1.

Performance of B/P and E/P strategies

To evaluate the relative usefulness of two summary measures of rm value, E and B, for
predicting future stock returns, we implement a series of trading rules with zero net
investment. First, at the rst trading date of October in each sample year, 19761990, we
rank all stocks in the sample based on earnings-to-price ratio (E/P) and book-to-price ratio
(B/P). We then construct four E/P (B/P) portfolios: portfolios 1, 2 and 3 are formed using
stocks with positive earnings (book value), and consist of stocks with the lowest 30%, the
medium 40%, and the highest 30%, respectively, in terms of the ranked values of positive
E/P (B/P); and stocks with negative earnings (book value) are assigned to Portfolio 0. It is
assumed that nancial statement information for year t is made public by the end of the
sixth month after scal-year ends. Note that, in calculating E/P and B/P, the closing price at
the last trading day of the sixth month after a rm's scal-year end is used as a deator for E
and B to avoid what Jaffe et al. (1989) call ``look-ahead bias'' and to make trading
strategies implementable.
Second, at the rst trading day of October in each sample year, we construct zero netinvestment hedge portfolio with long and short positions where the equal amount of fund is
allocated to each position (assuming no transaction cost): For both E/P and B/P portfolios,
the short position is taken for stocks in Portfolio 1, while the long position is taken for
stocks in Portfolio 3. Note that stocks in Portfolio 1 (Portfolio 3) have low (high) E/P or B/P
relative to stocks in the benchmark portfolio, i.e., Portfolio 2, and thus, that their current
prices at the time of portfolio formation are considered to be high (low), relative to intrinsic
values of the underlying stocks implied by earnings or book value, respectively. In other
words, we hypothesize that stocks in Portfolio 1 (Portfolio 3) are currently overvalued
(undervalued) relative to their intrinsic values, and thus, that their market prices will
decline (rise) gradually in the future.
Finally, the performance of the E/P or B/P strategy is evaluated by observing buy-andhold returns to the trading strategy for various holding periods up to 36 months beginning
in October of year t1 for scal year t. For each portfolio formation year, 19761990, we
compute the market-adjusted buy-and-hold returns for portfolio p up to month m (MARpm)
as below:
"
#
Np Y
m
m
Y
1 X
1 Rjt 1 RMt
(1)
MARpm
Np j1 t1
t1
where Rjt is the return on common stock for rm j in portfolio p in month t; and RMt the
return on the market portfolio in month t that is proxied by the Tokyo Stock Exchange
(TSE) value-weighted index return in month t, and Np denotes the number of stocks in
portfolio p. The above MAR metric measures the compounded buy-and-hold return earned
on portfolio p up to month m from the portfolio formation month in excess of the buy-andhold return earned on the market portfolio up to the same holding month.11
11

Although not reported, we also calculate raw buy-and-hold return (BHR) and size-adjusted BHR. The use of
alternative return metrics does not alter our conclusion.

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K.H. Bae, J.-B. Kim / Japan and the World Economy 10 (1998) 467485

As pointed out by Blume and Stambaugh (1983) and Ou and Penman (1989), buy-andhold returns have an advantage, as a measure of portfolio performance, over cumulative
returns in that the former does not require monthly rebalancing of portfolios, and thus,
involves lower transaction costs. Since it is presumed that at the portfolio formation date in
each year, the dollar amount invested in the long position is equal to the dollar amount
received from the short position (assuming no transaction cost), a positive return to the
trading strategy (or the hedge position) would be realized if the return to the long position
exceeds the return to the short position. MAR to the hedge position in a month is computed
as the difference between MARs to the long and short portfolios in the same month.
In Table 2, Panel A reports MAR on portfolios 0, 1, 2 and 3 for various holding periods
when portfolios are formed on the basis of ranked values of E/P, while Panel B reports the
same when portfolios are formed on the basis of ranked values of B/P. For E/P (B/P)
portfolios, at each portfolio-formation date, stocks with the lowest 30% of ranked E/P
(B/P) values are assigned to Portfolio 1, and stocks with the highest 30% of ranked values
of E/P (B/P) are assigned to Portfolio 3. Stocks with the medium 40% of ranked E/P (B/P)
values are assigned to Portfolio 2. Stocks with negative earnings (book value) are assigned
Table 2
Market-adjusted buy-and-hold returns to portfolios based on one-dimensional classifications by earnings-toprice ratio and book-to-price ratio
Panel A: E/P Portfolio
Portfolio

E/P

Beta

Size

Market-adjusted buy-and-hold returns

6 month

12 month 18 month 24 month 30 month 36 month

0
1
2
3
31
t-stat.
z-stat.

0.10
0.04
0.08
0.17

1.11
1.07
1.03
1.00

9.24
10.56
10.53
10.10

0.0270
0.0180
0.0084
0.0067
0.0247
5.35
5.53

0.0599
0.0387
0.0181
0.0285
0.0672
8.58
8.91

Market-adjusted buy-and-hold returns

0.1136
0.0649
0.0451
0.0430
0.1079
9.94
11.19

0.1179
0.1081
0.0554
0.0618
0.1699
12.75
12.76

0.1528
0.1637
0.0843
0.0746
0.2383
13.78
13.97

0.0932
0.2215
0.1223
0.0789
0.3004
14.68
15.68

Panel B: B/P Portfolio

Portfolio

B/P

Beta

Size

0
1
2
3
31
t-stat.
z-stat.

0.67
0.23
0.42
0.69

1.24
1.12
1.03
0.95

8.53
10.44
10.45
10.10

6 month

12 month 18 month 24 month 30 month 36 month

0.0457
0.0164
0.0047
0.0061
0.0225
4.89
5.44

0.1226
0.0484
0.0089
0.0381
0.0865
11.22
13.37

0.1732
0.0700
0.0276
0.0503
0.1203
11.13
14.09

0.2185
0.1090
0.0459
0.0774
0.1864
13.67
17.57

0.2083
0.1484
0.0696
0.0813
0.2297
13.10
17.76

0.1351
0.2040
0.1046
0.0742
0.2782
13.79
18.74

Note: 21 901 firm-year observations for the 19761990 period are used to construct portfolios. E/P denotes
earnings-to-price ratio and B/P denotes book-to-price ratio. Stocks with the lowest (highest) 30% of ranked E/P
or B/P are assigned to Portfolio 1 (Portfolio 3), while stocks with the medium 40% of ranked E/P or B/P are
assigned to Portfolio 2. Stocks with negative earnings or book value are assigned to Portfolio 0. Portfolios are
formed on the first trading day of October in each sample year.

K.H. Bae, J.-B. Kim / Japan and the World Economy 10 (1998) 467485

475

to Portfolio 0. The short and long positions are taken for stocks in Portfolio 1 and Portfolio
3, respectively. Although Portfolio 2 is not required for constructing zero net-investment
hedge portfolio, we report MAR for Portfolio 2 as a benchmark for evaluating the
performance of Portfolio 1 and Portfolio 3. In both Panels A and B of Table 2, reported
returns for each holding period are averages of MARs on the portfolios formed each year in
the 14-year portfolio-formation period, 19761990. The return to the hedge position
(Portfolio 31), as reported in the third row of both panels from the bottom, represents the
average of MARs to the trading strategy over the 14-year period, and thus, it can be
interpreted as a measure of the average protability of the trading strategy implemented
each year.
The results in both panels of Table 2 indicate that both earnings and book value are
useful indicators of a rm's intrinsic value. For both E/P and B/P portfolios, MARs to
Portfolio 1 (short position) are consistently lower for all months in the holding period than
MARs to the benchmark portfolio (Portfolio 2), while the opposite is true for MARs to
Portfolio 3 (long position). MARs to the hedge position, as reported in the third row from
the bottom of each panel, increase consistently up to the 36-month holding period, and are
relatively high in magnitude. For E/P portfolios, differences in MARs between portfolios 3
and 1 for 12-, 24-, and 36-month holding periods are 6.72, 16.99 and 30.04%, respectively,
while they are 8.65, 18.64, and 27.82%, respectively, for B/P portfolios. Note that MARs to
the hedge position for B/P portfolios are higher than those for E/P portfolios for the 12-, 18-,
24-month holding periods, while the opposite is true for the 6-, 30-, and 36-month periods,
although the differences are not large. Note further that for both E/P and B/P strategies, the
short portfolio contributes more to MARs to the hedge position for all holding periods than
does the long portfolio.
To test for statistical signicance of MARs to the hedge position, we apply both
parametric t-test and nonparametric Wilcoxon signed-rank z-test. The last two rows of each
panel report the results of both tests for various holding periods. Both tests show that the
returns to the hedge position are highly signicant for all cases.
The signicant differences in MARs between portfolios 3 and 1 could be observed if
stocks in Portfolio 3 are relatively riskier than stocks in Portfolio 1. However, our results do
not appear to support this `differential risk' argument for the following reasons:12 First, as
reported in Table 2, the difference in the median values of beta and rm size between the
two portfolios is not large. Furthermore, for both E/P and B/P portfolios, average beta for
stocks in Portfolio 3 is slightly lower than that for stocks in Portfolio 1, which is
contradictory to the `differential risk' argument. Second, although not reported, in an
attempt to control for the well-known size effect, we have also calculated size-adjusted
buy-and-hold return to each portfolio, and found that the differences in size-adjusted
returns between portfolios 3 and 1 are signicant in all cases. This result is inconsistent
with the `differential risk' to the extent that rm size proxies for the risk.
In short, the results reported in Table 2 show that one can construct protable trading
strategies using accrual earnings or book value of equity, indicating that the two accounting
indicators of rm value are individually useful for predicting future stock returns in Japan,
12

In the Section 3.2, this issue will be further examined through regression analysis.

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K.H. Bae, J.-B. Kim / Japan and the World Economy 10 (1998) 467485

and that book value is at least as useful as (and more useful for certain holding periods than)
earnings for capturing a rm's prospects and/or their effect on rm value.
3.2.

Performance of combined strategies

In Section 3.1, we evaluate the individual usefulness of earnings (E) and book value (B)
by observing the performance of zero net-investment hedge portfolios formed on the basis
of ranked values of E/P or B/P alone, and nd that both indicators are value-relevant. In this
section, we further examine whether or not both indicators capture the same aspect of rm
value. If some aspects of rm value are captured by one indicator, but not by the other, the
trading strategy based on a combination of both E/P and B/P (hereafter, combined strategy)
would yield higher returns than does the trading strategy based solely on E/P or B/P alone.
To examine this possibility, we implement various combined strategies which incorporate both E and B information in constructing zero net-investment hedge portfolios. At each
portfolio-formation date in the 14-year sample period, we assign stocks to the nine cells as
below, using the ranked values of both E/P and B/P:
E/P1 Portfolio
E/P2 Portfolio
E/P3 Portfolio

B/P1 Portfolio
1. E/P1 and B/P1
4. E/P2 and B/P1
7. E/P3 and B/P1

B/P2 Portfolio
2. E/P1 and B/P2
5. E/P2 and B/P2
8. E/P3 and B/P2

B/P3 Portfolio
3. E/P1 and B/P3
6. E/P2 and B/P3
9. E/P3 and B/P3

As a result of this two-path sort, we construct nine E/P and B/P combined portfolios.
Note, for example, that if both E/P and B/P values for a stock fall within the lowest 30
percentile of both E/P and B/P distributions, such a stock is assigned to the E/P1 and
B/P1 portfolio. Once the nine E/P and B/P portfolios are formed, we calculate MAR
for each portfolio by applying the same procedures as described in the Section 3.1. To
assess the incremental usefulness of earnings or book value over the other for constructing protable trading strategies, we assign stocks in the E/P3 and B/P3 portfolio (E/P1
and B/P1 portfolio) to the long (short) position. We compute the return to the combined
strategy as the difference in MARs between the long and short portfolios over various
holding periods up to 36 months. It is hypothesized here that if earnings or book value
information is incrementally useful over the other, MARs to the E/P and B/P combined
strategy should be consistently greater than MARs to the corresponding strategy based
on E/P or B/P alone.
Table 3 reports MARs to the E/P1 and B/P1 and E/P3 and B/P3 portfolios for various
holding periods up to 36 months. Although MARs to other combined portfolios (e.g., E/P2
and B/P3 portfolio) are not shown in Table 3 for brevity, we can report that regardless of the
return metrics used for calculating MARs, the E/P1 and B/P1 portfolio yields the lowest
MARs among the nine combined portfolios over all holding periods, while the E/P3 and B/
P3 portfolio yields the highest MARs. When the short (long) position is taken for stocks in
the E/P1 and B/P1 portfolio (the E/P3 and B/P3 portfolio), MARs to the hedge position, as
reported in the third row from the bottom, is substantially higher for all holding periods
than MARs to the corresponding trading strategy based on E/P or B/P alone (as reported in
the third row from the bottom of Panel A or B of Table 2, respectively). MARs to the

K.H. Bae, J.-B. Kim / Japan and the World Economy 10 (1998) 467485

477

Table 3
Market-adjusted buy-and-hold returns to portfolios based on two-dimensional classifications by earnings-toprice ratio and book-to-price ratio
Portfolio

E/P

1. B/P1
0.04
and E/P1
9. B/P3
0.18
and E/P3
91
t-statistics
z-statistics

B/P

Beta

Size

Market-adjusted buy-and-hold return

6 month

12 month 18 month 24 month 30 month 36 month

0.21

1.12

10.74

0.0310

0.0692

0.1126

0.1639

0.2336

0.3152

0.70

0.93

10.01

0.0044

0.0581

0.0787

0.1409

0.1542

0.1842

0.0354
4.99
5.41

0.1273
10.63
12.13

0.1913
11.60
13.04

0.3048
14.00
19.21

0.3878
13.87
16.74

0.4994
15.17
18.07

Note: 20 412 firm-year observations with positive earnings and book value for the 19761990 period are used to
construct portfolios based on two-dimensional sorts. E/P denotes earnings-to-price ratio and B/P denotes bookto-price ratio. The E/P(1) and B/P(1) portfolio consists of stocks with the lowest 30% of ranked values of E/P
and B/P while the E/P(3) and B/P(3) portfolio consists of the highest 30% of ranked values of E/P and B/P.
Portfolios are formed on the first trading day of October in each sample year.

combined strategy for the 12-, 24-, and 36-month holding periods are 12.73, 30.48 and
49.94%, respectively, which are much higher than MARs to the E/P strategy (6.72, 16.99,
and 30.04%) and those to the B/P strategy (8.65, 18.64, and 27.82%), as reported in Panels
A and B of Table 2, respectively. As shown in the last two rows of each panel, both t- and ztests indicate that differences in MARs between the long portfolio (E/P3 and B/P3) and the
short portfolio (E/P1 and B/P1) are highly signicant for all cases. Consistent with the
results for trading strategies based on E/P or B/P alone (as reported in Table 2), the short
position contributes much more to MAR to the hedge position of the combined strategy for
all holding periods than does the long position. In sum, the results reported in Table 3
suggest that earnings (or book value) capture some aspects of rm value that are not
captured by book value (or earnings).
3.3.

Further analysis: Effect of cross corporate ownership and real estate holding

The results reported in Table 3, along with those in Table 2, indicate that accrual
earnings and book value (or E/P and B/P) for Japanese rms are not only individually
useful but also incrementally useful for providing improved portfolio decisions. However,
these results do not necessarily implies that one measure is more useful than the other for
predicting stock returns. In this section, we conduct multivariate regression analyses to
further examine whether the predictive ability of E/P or B/P is dominated by the other. In
doing so, our analysis also focuses on the issue of whether the predictive ability of each
accounting measure is differentially affected by two important rm-specic characteristics
in Japan, namely, the degree of cross corporate ownership and the degree of a rm's real
estate holding.
Evidence shows that about two-thirds of outstanding shares in the Japanese equity
market are cross-owned by afliated rms and nancial institutions, such as main banks

478

K.H. Bae, J.-B. Kim / Japan and the World Economy 10 (1998) 467485

(Yasuda and Lin, 1988; Prowse, 1990, 1992 and Cooke, 1996). This ownership structure
has important implications on the usefulness of accounting numbers for predicting stock
returns. Cready (1988), Lee (1992) and Kim et al. (1997), among others, show that large
non-individual shareholders may have informational advantage over small individual
investors in assimilating value-relevant information. Further, Jacobson and Aaker
(1993) and Cooke (1996) argue that large non-individual shareholders (who own stocks
through cross ownership) hold equity shares not for the sake of short-term capital
appreciation but for maintaining long-term business relationships with other companies.
In this environment, useful information about a rm's prospect is more likely to be
conveyed to investors through direct communication between large (cross-held) shareholders (e.g., afliated rms) and management in a timely fashion. As a result, currently
observed prices would impound value-relevant information (including accounting information) more efciently for rms with high cross ownership (CRH) than for those with low
CRH. This suggests that contemporaneous associations between current stock prices or
returns and accounting fundamentals, such as earnings and book value, are likely to be
stronger for high-CRH rms than for low-CRH rms. In a related vein, one can argue that
the ability of earnings and book value to predict future stock returns is likely to be weaker
for high-CRH rms than it is for low-CRH rms.13 On the other hand, Japanese GAAPs do
not require earnings of its (cross-owned) subsidiaries to be included in nancial statements
(French and Poterba, 1991; Solnik, 1994). In addition, investments by a rm into other
afliated rms are valued at their original costs unless the original costs are higher than the
associated market values. Therefore it is likely that the information quality of reported
earnings (and thus book value) would be lower, other things being equal, for high-CRH
rms than for low-CRH rms (Cheung et al., 1998).
Until the early 1990s, prices of real estate assets in Japan were the highest in the world.
Previous research shows that there exists a positive relation between stock prices and real
estate prices in Japan (Boon, 1989; Frankel, 1991; Frankel, 1993). Further, French and
Poterba (1991) report that despite the huge parity in valuation relatives between the US and
Japan, Tobin's Q-ratios for rms in both countries remained at about the same level for
most of the 1980s, and that the replacement cost of capital assets in Japan increased almost
as much as stock prices during the same period. The above evidence suggests that market
participants in Japan take into account a rm's holding of real estate assets, such as land
and building, when valuing equity shares.
In Japan, values of real estate assets are recorded at their original acquisition costs
with no supplemental information provided for their current costs (Choi and Mueller,
1992; Cheung et al., 1998). Real estate prices in Japan skyrocketed from the mid1970s until the early 1990s (which covers the sample period for this research), thus
leading to the large deviation of their market values from the associated book values.
This downward bias in reported earnings and book value may distort their ability to
predict future stock returns, while the directional effect of this bias on the predictive
ability is an empirical issue.

13

Stated alternatively, trading strategies based on earnings and book value would be less profitable for high
CRH firms than for low CRH firms.

K.H. Bae, J.-B. Kim / Japan and the World Economy 10 (1998) 467485

479

To provide empirical evidence on the above issues, we posit the following regression
model which is similar in spirit to Fama and French (1992):
MAR1jt1 0 1 B=Pjt 2 B=PDUMjt 3 CRHjt  B=Pjt
4 REHjt  B=Pjt 5 E=Pjt 6 E=PDUMjt
7 CRHjt  E=Pjt 8 REHjt  E=Pjt
9 ln Pjt 10 Bjt "jt

(2)

where MAR1jt1 represents 1-year (ahead) market-adjusted buy-and-hold returns for rm j

in year t1;14 B()/Pjt represents book-to-price ratio for rm j with positive book value in
year t; E()/Pjt represents earnings-to-price ratios for rm j with positive earnings in year t;
B/PDUMjt (E/PDUMjt) is a dummy variable which has the value of unity if rm j has
negative earnings (book value) in year t and is zero otherwise; CRHjt (REHjt) a slope
dummy variable which has the value of unity if the degree of cross ownership (real estate
holding) for rm j in year t is above the cross-sectional median of the sample;15 ln Pjt the
natural log of market capitalization for rm j as of the end of the sixth month after scalyear end in year t; Betajt the market risk for rm j in portfolio-formation year t that is
estimated using past 5-year monthly returns ending scal-year end; and "jt denotes
unspecied random factors. Eq. (2) is specied in an intertemporal (as opposed to
`contemporaneous') setting with lagged independent variables. The dependent variable,
MAR1, is a measure of stock return subsequent to scal year t, while all the predictor
variables are measured using information available by the end of scal year t. Eq. (2) is
therefore predictive in nature.
Out of a total of 21 901 rm-year observations used for constructing E/P and E/P
portfolios, 15 417 are used to estimate Eq. (2), due to data requirements for computing the
Beta, CRH and REH variables.16 Regression results for various versions of Eq. (2) are
reported in Table 4. The reported t-values are on an adjusted basis using White's (1980)
heteroskedasticity-consistent covariance matrix. Note that model (1) includes only the
B/P-related variables while model (2) includes only the E/P-related variables. Results for
models (1) to (4) reveal that B()/P, E()/P, and ln P are highly signicant with expected
signs, while beta is insignicant, a nding consistent with Fama and French (1992) and
Chan et al. (1991). Among the four explanatory variables, the size variable turns out to be
the most signicant.
Further, results for models (1) and (2) show that the B/P effect and, to a lesser extent, the
E/P effect are sensitive to the extent to which a rm's shares are cross-held. The crossholding dummy variables for B/P (i.e., CRH*B/P in model 1) is highly signicant, while
that for E/P (i.e., CRH*E/P in model 2) is insignicant at the 5% level. However, both the
slope dummy variables have negative signs, which is consistent with our expectation. This
indicates that intertemporal relations between MAR1 and B/P (and E/P) are inversely
14

More specifically, MAR1jt is compounded monthly buy-and-hold return on stock j for the 12-month period
beginning in October of year t1) in excess of TSE value-weighted index return for the same period. Using a
similar procedure as defined in Eq. (1), we compute MAR1 for each firm.
15
Note, for example, that the coefficient for B()/P is 13 for high-CRH firms while it is 1 for low-CRH
firms.
16
Note that beta calculation requires us to sacrifice 5 year backward observations prior to portfolio formation.

0.0521
(7.42)

0.0179
(3.25)

0.3493
(12.27)

0.0102
(1.19)

0.2862
(8.59)

0.3452
(10.41)

0.0536
(7.56)

Interc.

BPDUM b CRH c*B()/P

0.1393 0.0409 0.0717

(6.47) (0.67)
(2.98)

0.0862 0.0831 0.0339

(4.52) (1.57)
(2.23)

0.1399 0.1567 0.0502

(7.63) (2.58)
(3.33)

B()P a

0.0164
(0.69)

0.0112
(0.74)

0.0095
(0.63)

0.0271 0.6570
(0.38)
(3.75)

0.1311
(1.20)

0.0203 0.3205 0.0549

(0.30) (1.90) (0.74)

0.1334
(1.29)

0.0780
(1.15)

0.0209
(0.30)

0.0328
(11.86)

0.0300
(11.05)

0.0334
(13.24)

EPDUM b CRH c*E()/P REH d*E()/P ln P f

0.1844 0.7696 0.1050

(2.56) (4.39) (1.41)

REH d*B()/P E()P e

Table 4
Regression of 1-year market-adjusted buy and hold returns on fundamental variables

0.0041
(0.53)

Beta g

0.0067

0.0143

0.0148

0.0000

0.0134

0.0023

0.0050

Adj. R2

480
K.H. Bae, J.-B. Kim / Japan and the World Economy 10 (1998) 467485

03183
(7.85)

0.2876
(812)

0.0924 0.0205 0.0492

(4.31) (0.36)
(1.97)

0.0967 0.0263 0.0491

(4.57) (0.47)
(1.97)
0.0166
(0.69)

0.0172
(0.71)
0.1115 0.2685
(1.62) (1.52)

0.1083 0.2816
(1.58) (1.59)
0.1012
(0.89)

0.1040
(0.91)
0.1704
(1.61)

0.1699
(1.61)
0.0312
(10.41)

0.0299
(10.47)
0.0137
(1.68)

0.163

0.161

Represents book-to-price ratio for the firms with positive book value.
Are dummy variables that have the value of unity if earnings and book value, respectively, are negative and are zero otherwise.
c
Is the dummy variable that has the value of unity if the degree of corporate cross ownership (defined as book value of investment by a firm into other firms divided by
book value of its net assets) is above its sample median and zero otherwise.
d
Is the dummy variable that has the value of unity if the degree of a firm's real estate holding (defined as the book value of a firm's real estate assets, i.e., land and
building, divided by book value of total assets) is above its sample median, and zero otherwise.
e
Represents earnings-to-price ratio for the firms with positive earnings.
F
Is the natural log of market capitalization as of the end of the sixth month after fiscal-year end.
g
Represents market-model beta that is estimated using past 5-year monthly returns ending fiscal-year end. Each regression is estimated using 14 469 firm-year
observations.
Note: MAR denotes 12-month market-adjusted buy-and-hold returns.

K.H. Bae, J.-B. Kim / Japan and the World Economy 10 (1998) 467485
481

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K.H. Bae, J.-B. Kim / Japan and the World Economy 10 (1998) 467485

affected by the degree of cross-holding. In other words, the ability of B/P (and to a lesser
extent E/P) to predict future stock returns is lower for rms with high cross holding than for
those with low cross holding.17 On the contrary, the real estate dummy variables for both
B/P and E/P (i.e., REH*B/P and REH*E/P) are insignicant at the conventional level,
indicating that both the B/P and E/P effects are insensitive to the degree of a rm's real
estate holding.
When the B/P-related variables are included along with rm size (model 5), both B()/P
and CRH*B/P are still signicant. On the other hand, when the E/P-related variables are
included along with rm size (model 6), all E/P-related variables become insignicant with
size being still signicant. The above results suggest that the E/P effect is dominated by the
size effect while the B/P effect is not.
In model 7, the B/P related variables are included along with the E/P-related variables.
The result shows that B()/P is signicant while E()/P is insignicant. This result,
coupled with those for models (1) and (2), suggests that the E/P effect is dominated by the
B/P effect. Note also that consistent with the results for models (1) and (2), the crossholding dummy variables are signicant only for B/P, while the real estate dummy
variables are insignicant for both B/P and E/P.
Model 9 includes all the variables in Eq. (2), while model 8 includes all except Beta. The
results for models (8) and (9) conrm our ndings described above: (1) the E/P effect is
dominated by either the B/P or size effect, a nding consistent with Fama and French
(1992) and Chan et al. (1991); (2) the cross-holding dummy variables are signicant only
for B/P with an expected (negative) sign, indicating that the B/P effect is inversely affected
by the extent to which a rm's shares are cross-held; and (3) Beta is insignicant with an
unexpected (negative) sign.
In a nutshell, the results reported in Table 4 reveal the following: First, B/P is signicant
both individually and incrementally in predicting stock returns in Japan, while E/P is
signicant only individually, indicating that the E/P effect is dominated by the B/P effect.
This is consistent with the argument that book value contains value-relevant information
that is not captured by earnings. Second, the predictive ability of B/P is inversely affected
by the extent to which a rm's shares are cross-held, while it is insensitive to the potential
downward bias induced by the deviation of the market value of real estate assets from the
associated book value, proxied by the degree of a rm's real estate holding.
4.

Summary and concluding remarks

In an attempt to evaluate the relative usefulness of accrual earnings and book value for
predicting stock returns in Japan, we implement a series of simple trading strategies (with
zero net investment) that are based on ranked values of earnings-to-price ratios, book-toprice ratios, and combinations of both. We then observed market-adjusted buy-and-hold
returns to the trading strategies for various holding periods up to 36 months.

17

Note, for example, that, for the low CRH sample, the B/P coefficient is 0.1399, while it is 0.0872
(0.13990.0502) for the low CRH sample.

K.H. Bae, J.-B. Kim / Japan and the World Economy 10 (1998) 467485

483

Our analysis shows that both earnings and book value have the ability to provide for
protable trading strategies or improved portfolio decisions. This indicates that the two
basic accounting fundamentals capture equity values that are not fully reected in currently
observed prices. Our analysis further shows that, relative to the trading strategy based on
earnings or book value alone, the trading strategy based on a combination of both earnings
and book value yields substantially higher returns for all cases. This suggests that book
value (or earnings) captures some aspects of equity value that are not captured by earnings
(book value). This nding is consistent with the notion that while both are value-relevant,
accrual earnings and book value are not a substitute for each other, but could be a
complement for each other.
Our multivariate regression results further indicate that in Japan, the book-to-price ratio,
combined with rm size, explains most cross-sectional variation in (1-year ahead) stock
returns. The earnings-to-price effect is dominated by either the book-to-price or the size
effect or both effects, a nding consistent with the US results of Fama and French (1992).
We further document that the predictive ability of B/P (and to a lesser extent E/P) is
inversely related to the extent to which a rm's shares are cross-held among afliated rms,
while it is insensitive to the degree of a rm's real estate holding.
In conclusion, our results do not support the popular perception that reported accounting
numbers in Japan are of little use for investment decisions (e.g., Viner, 1988; Zielinski and
Holloway, 1991). In particular, our results reveal that the book value of equity are useful for
providing improved portfolio decisions or for predicting future stock returns, while its
usefulness is sensitive to the extent to which a rm's shares are cross-held among afliated
rms. The observed signicance of the cross-ownership variable suggests that further
research on the impact of institutional characteristics on rm valuation in Japan remains
desirable to obtain additional insight into what determines the huge difference in valuation
relatives between Japanese and other developed equity markets.
Acknowledgements
Kim gratefully acknowledges nancial support for this research from The Hong Kong
Polytechnic University Central Research Grant (Grant # 353-064) and CAAA/Deloitte and
Touche Research Grant. An earlier version of the manuscript was presented at the 1996
Annual Meeting of American Accounting Association (AAA). We have received useful
comments and suggestions from the editor of this journal, K. Hung Chan, Gene Imhoff,
Sandra Ho, Roland Lipka, Kazuyuki Suda, Bill Scott, Dan Thornton, participants of the
1996 AAA meeting and the discussant (Robert Freeman), participants of faculty workshops at The Chinese University of Hong Kong and The Hong Kong Polytechnic
University, and in particular an anonymous referee. The usual disclaimer applies.

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