Stephen Penman

The Articulation of Price-Earnings Ratios and Market-to-Book Ratios and the Evaluation of Growth

Abstract:
A study was conducted to interpret the price-earnings ratio (P/E) and the market-to-book ratio (P/B) and describe their articulation. It also aimed to explain the role of book rate-of-return on equity in determining the ratios and the relation between them. The P/E ratio signifies future growth in earnings positively related to expected future return on equity and negatively related to current return on equity. On the other hand, the P/B ratio indicates only expected future return on equity. The articulation of the two was based on the dividend discount formula and the clean-surplus accounting relation, in addition to a description of normal expected return on equity that equals cost of capital. Empirical evidence showed that return on equity reflects differential P/B ratios but not P/E ratios, except in the extremes. However, current return on equity is not a good indicator of P/E.

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