Investments, tenth edition

 Example  19.4 

Price to Book and Growth Options 

 Another measure used to place firms along a growth versus value spectrum is the    price–

earnings (P/E) ratio.      In fact, we saw in the last chapter that the ratio of the present value 

of growth options to the value of assets in place largely determines the P/E multiple. While 

low-P/E stocks allow you to pay less per dollar of  current  earnings, the high-P/E stock may 

still be a better bargain if its earnings are expected to grow quickly enough.  

5

  

  

 Many analysts nevertheless believe that low-P/E stocks are more attractive than high-

P/E stocks. And in fact, low-P/E stocks have generally been positive-alpha investments 

using the CAPM as a return benchmark. But an efficient market adherent would discount 

this track record, arguing that such a simplistic rule could not really generate abnormal 

returns, and that the CAPM may not be a good benchmark for returns in this case. 

  

5

 Remember, though, P/E ratios reported in the financial pages are based on  past  earnings, while price is deter-

mined by the firm’s prospects of  future  earnings. Therefore, reported P/E ratios may reflect variation in current 

earnings around a trend line. 

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 Financial 

Statement 

Analysis 

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 In any event, the important points to remember are that ownership of the stock conveys 

the right to future as well as current earnings and, therefore, that a high P/E ratio may 

best be interpreted as a signal that the market views the firm as enjoying attractive growth 

opportunities. 

 Before leaving the P/B and P/E ratios, it is worth pointing out an important relationship 

between  them:   

 ROE

5

Earnings

Book value

5

Market price

Book value

4

Market price

Earnings

 

 (19.5)   

5 P/B ratio 4 P/E ratio

 By rearranging the terms, we find that a firm’s P/E ratio equals its price-to-book ratio 

divided by ROE:   

P

E

5

P/B

ROE

 

Thus a company with a high P/B ratio nevertheless can have a relatively low P/E if its ROE 

is high enough. 

 Wall Street often distinguishes between “good firms” and “good investments.” A good firm 

may be highly profitable, with a correspondingly high ROE. But if its stock price is bid up to a 

level commensurate with this ROE, its P/B ratio will also be high, and the stock price may be 

a relatively large multiple of earnings, thus reducing its attractiveness as an investment. The 

high ROE of the firm does not by itself imply that the  stock  is a good investment. Conversely, 

troubled firms with low ROEs can be good investments if their prices are low enough. 

  Table 19.10  summarizes the ratios reviewed in this section.  

 

 

 What were GI’s ROE, P/E, and P/B ratios in the year 2013? How do they compare to the industry average 

ratios, which were: ROE  5  8.64%; P/E  5  8; P/B  5  .69? How does GI’s earnings yield in 2013 compare to the 

industry average? 

 CONCEPT CHECK