Penetrating the book-to-market black box: The R&D effect

The book‐to‐market (BM) phenomenon – the positive association between BM and subsequent returns – looms large among capital market enigmas. Economic theory postulates that the difference between market and book values of companies reflects their future abnormal profits. We capture these abnormal profits for a large sample of science‐based companies by estimating the value of the off‐balance sheet investment generating those profits – the value of R&D capital – and show empirically: (i) Firms’ R&D capital is associated with their subsequent stock returns. (ii) For R&D intensive firms, this ‘R&D effect’ subsumes the ‘book‐to‐market effect.’ (iii) The association between R&D and subsequent returns appears to result from an extra‐market risk factor inherent in R&D, rather than from stock mispricing. We thus provide an explanation for the book‐to‐market phenomenon of R&D companies.