Decomposing the Price to Book Ratio
I project the price to book ratio onto a vector of cash flow variables and thereby decompose its cross sectional variation into two components. The fundamental component is the fitted value based on the cash flow variables, and the transitory component is the residual term. I show that firms with high fundamental component have high price to book ratio and high subsequent stock return, while firms with high transitory component have high price to book ratio and low subsequent stock return. This prediction is confirmed in the data, and it also applies to other valuation signals including price to dividend, price to earnings and price to debt ratio. Moreover, I show that the fundamental component predicts return because it captures investors' sluggish adjustment, which leads to underreaction to cash flow news; the transitory component predicts return because it captures return reversal, which comes from overreaction to discount rate news.