Risky Value

We use an accounting-based approach to link two primary measures of ‘value' to expected returns for countries: earnings-to-price (E/P) and book-to-price (B/P). We document that when country-level earnings are less affected by accounting distortions related to conservative accounting for uncertain investments, E/P is close to a sufficient statistic for expected returns. However, when earnings are more affected by accounting distortions, B/P is needed. We find that high B/P countries are, on average, facing temporarily depressed current earnings, in part due to conservative accounting for uncertain investments, and their recovery in future earnings growth is uncertain. Countries with high B/P also exhibit greater downside sensitivity to global earnings growth, which supports our interpretation that B/P reflects systematic risk in future earnings growth. We also find stronger results in low E/P countries which points to the joint importance of E/P and B/P. Further, cross-country differences in unconditional accounting conservatism help to explain differences in the relative importance of E/P and B/P