Why does book-to-market value of equity forecast cross-section stock returns?

In this paper, we derive a model of book-to-market value of equity based on the present value model and estimate it using panel data on individual stocks. We explicitly include in the model all the determinants of book-to-market except the firm-specific discount rate, which we capture using fixed individual effects in the panel data model. The model is particularly successful, explaining nearly 90% of the time series and cross-section variation in the ratio of book-to-market value of equity. Moreover, the estimated firm-specific fixed effects are more successful than the most recent book-to-market value of equity in forecasting subsequent returns. This is consistent with an efficient market in which book-to-market is a proxy for risk.