Question

10. Google is a big stock and LinkedIN is a small stock, but at the same time Google has a higher book-to-market ratio than LindedIN. According to the size effect, Google should have lower return than LinkedIN because its size is bigger; but according to the value effect, Google should have higher return than LinkedIN because its book to market ratio is higher. Is the above statement correct? Why? (2)

Answer 1

The word book to market ratio indicates the company value with respect to comparison of book value to the value in the market. Size effect occurs largely when we compare either two small companies or very small companies. There is hardly any difference in return for a large or a medium company. Value effect occurs when there is increase/ decrease in no of shares. Suppose if a stock split occurs for a company then the actual value of shares remain the same. However during bonus issue or right issue new shares are issued thereby increasing the value of share. Small companies who have high book to market ratio generate higher returns than with big firms who have low book market ratio. Hence the above statement is incorrect.