Frankel & Lee find residual income predicts stock returns

Accounting Valuation, Market Expectation, and the Book-to-Market Effect by Frankel & Lee

Accounting-based valuation theory suggests that a firm’s value (V) is a combination of its book value (B) and market expe

ctations of future earnings. We empirically evaluate the ability of this model to explain the book-to-market (B/P) effect. We find that our empirical proxies of V dominate B in cross-sectional correlations with price, and that the resulting V/P ratios also predict cross-sectional returns. In addition, we find that errors in analyst consensus forecasts are predictable, and that returns from trading

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on these predictable errors account for much of the B/P effect.

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