Dissecting the Value Premium: A Novel Market-to-Book Decomposition

This study introduces a novel market-to-book value components (M/BVC) decomposition model, surpassing traditional two-component models by breaking down the market-to-book ratio (M/B) into five detailed components. This model significantly refines the understanding of the factors driving the value premium, emphasizing the critical role of retained earnings (RE) in predicting stock returns. Through a rigorous analysis across Fama-French industries, the authors reveal the model's enhanced predictive power, particularly highlighting firm-specific errors and the value-to-RE component as key predictors of stock performance. The authors' approach, combining portfolio sorts analysis and firm-level return regressions, confirms the persistence of the value premium and identifies specific valuation components as instrumental in forecasting stock returns. This research contributes to asset pricing theory by providing a deeper insight into the mechanics of the value premium, offering implications for both academic research and investment practices.