Book-to-Market Equity, Financial Leverage, and the Cross-Section of Stock Returns

Abstract

I propose a new dynamic model of the firm that links operating leverage to both value premium and book-leverage premium in stock returns. Value firms are low-productivity firms with either high operating leverage or high financial leverage. Firms with high operating leverage maintain low book leverage ratios. When operating leverage is economically significant, both value firms and low book-leverage firms can have high equity risk premiums. In particular, value premium becomes positive while book-leverage premium becomes negative. Without operating leverage, the signs of these premiums are reversed. The model captures quantitatively several important properties of the cross-section of stock returns.