The fundamental-to-market ratio and the value premium decline

Abstract

Recent evidence indicates the value premium declined over time. We argue this decline happened because book equity, B E , is no longer a good proxy for fundamental equity, F E , defined as the present value of cash flows under a common discount rate across firms. Specifically, we estimate F E for public US firms over time and find that the premium associated with the fundamental-to-market ratio, F E / M E , subsumes the B E / M E premium and has been relatively stable while the cross-sectional correlation between F E / M E and B E / M E decreased over time, inducing an apparent decline in the value premium. We also show that F E / M E captures the value premium better than several alternative value signals beyond B E / M E .