Investments, tenth edition

  Market Price Ratios: Growth versus Value 

 The     market–book-value  ratio    (P/B) equals the market price of a share of the firm’s common 

stock divided by its  book value,  that is, shareholders’ equity per share. Some analysts consider 

the stock of a firm with a low market–book value to be a “safer” investment, seeing the book 

value as a “floor” supporting the market price. These analysts presumably view book value 

as the level below which market price will not fall because the firm always has the option 

to liquidate, or sell, its assets for their book values. However, this view is questionable. In 

fact, some firms do sell below book value. For example, in mid-2012, shares in both Bank 

of America and Citigroup sold for less than 50% of book value. Nevertheless, a low market–

book-value ratio is seen by some as providing a “margin of safety,” and some analysts will 

screen out or reject high-P/B firms in their stock selection process. 

 In fact, a better interpretation of the market-price-to-book ratio is as a measure of 

growth opportunities. Recall from the previous chapter that we may view the two com-

ponents of firm value as assets in place and growth opportunities. As the next example 

illustrates, firms with greater growth opportunities will tend to exhibit higher multiples of 

market-price-to-book value.  

 Consider two firms, both with book value per share of $10, both with a market capital-

ization rate of 15%, and both with plowback ratios of .60. 

 Bright Prospects has an ROE of 20%, which is well in excess of the market capitaliza-

tion rate; this ROE implies that the firm is endowed with ample growth opportunities. 

With ROE   5   .20, Bright Prospects will earn $2 per share this year. With its plowback 

ratio of .60, it pays out a dividend of  D  

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   5  (1  2  .6)  3  $2  5  $.80, has a growth rate of 

 g   5   b   3  ROE  5  .60  3  .20  5  .12, and a stock price of  D  

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 /( k   2   g )  5  $.80/(.15  2  .12)  5  

$26.67. Its price–book ratio is 26.67/10  5  2.667. 

 In contrast, Past Glory has an ROE of only 15%, just equal to the market capital-

ization rate. It therefore will earn $1.50 per share this year and will pay a dividend of 

 D  

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   5  .4 3 $1.50  5  $.60. Its growth rate is  g   5   b   3  ROE  5  .60  3  .15  5  .09, and its stock 

price is  D  

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 /( k   2   g )  5  $.60/(.15  2  .09)  5  $10. Its price–book ratio is $10/$10  5  1.0. Not 

surprisingly, a firm that earns just the required rate of return on its investments will sell 

for book value, and no more. 

 We conclude that the market-price-to-book-value ratio is determined in large part by 

growth prospects.