Are PE- and MB-Ratios Susceptible to Accruals, Growth, or Profitability?

Abstract

Price Earnings- and Market Book-ratios presume a systematic link between financial statement data and company value. We analyze this relationship in a steady state model with overlapping capacity investments where company value is inferred from a constant growth residual income model. We investigate the joint influence of accruals, growth, and profitability on the ratios and evaluate distortions in relation to economic benchmarks. Exemplary we assess the biases that result from linear depreciation and direct expensing. The overall results indicate, that the PE-ratio is less sensitive to the modeled influences compared to the MB-ratio, for which we find large biases. Both ratios are more susceptible to conservatism/liberalism induced by direct expensing than to biases induced through linear depreciation.

Keywords: Price earnings ratio, market to book ratio, steady state model, neutral accounting, accrual accounting

JEL Classification: G31, M41