Abstract
We examine the previously documented effect between a firm’s FSCORE and book-to-market ratio proposed by Piotroski and So (2012) and analyze the authors’ expectation errors hypothesis from a present value perspective. We find a strong value premium which is concentrated among firms where book-to-market implied expectations are incongruent with underlying fundamental strength. Using the decomposition of variation in book-to-market ratios motivated by Cohen et al. (2003), we show that the observed effect between a firm’s FSCORE and book-to-market ratio is attributable to mispricing as the variation is mostly due to variation in expected returns rather than variation in expected profitability.
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