Going Negative: What to Do with Negative Book Equity Stocks

Abstract

A firm’s book equity is a measure of the value held by a firm’s ordinary shareholders. Increasingly, it is being reported as a negative number. Since the firm’s limited liability structure means that shareholders’ value cannot be negative value, negative book equity has no obvious interpretation. Consequently, both practitioners and academics typically omit such stocks. While these stocks are small in number they are disproportionately represented in extreme value/growth sectors, and therefore can have an impact on applications where “value” is defined in terms of book equity. We propose a new approach that classifies negative book equity stocks across the value/growth spectrum by considering how close their returns correspond to stocks that fit more obviously into these classifications. We find that this new value factor, which includes negative book equity stock, is economically and statistically different from the old value factor that excludes such stocks. Although we illustrate how this approach can be used to classify negative book equity stock, the approach is quite general and may be used whenever particular accounting data are unavailable or otherwise suspect.