Expected P/E, Residual P/E, and Stock Return Reversal: Time-Varying Fundamentals or Investor Overreaction?

Abstract

We decompose P/E ratios into a fundamental component and a residual component that cannot be explained by the firm or economic fundamentals. Purging the fundamental component from observed P/E ratios, we find that portfolios based on residual P/E ratios exhibit performance reversal only in overbid glamour stocks; hence over-optimism is more prevalent than over-pessimism.