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More to the Story

There are stocks that trade at low prices, relative to book value, that are not undervalued. As noted earlier in the chapter, low price-to-book ratios can be attributed to high risk or low returns on equity. In this section, you will consider the characteristics of the stocks in the low price-to-book portfolio and examine potential problems for investment strategies.

High-Risk Stocks

Is it possible that the higher returns earned by low price-to-book stocks can be explained by the fact that they are riskier than average? Some of the studies referenced in the last section attempted to test for this hypothesis by computing returns adjusted for risk: excess returns. The earlier ones did so by estimating the betas and returns after adjusting for differences in betas for low price-to-book stocks and concluded that these stocks still made excess returns. Thus, stocks with low price-to-book value ratios earn excess returns relative to high price-to-book stocks if you use conventional measures of risk and return.


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