Structural Properties of the Price-to-Earnings and Price-to-Book Ratios

Posted: 27 Mar 2016

See all articles by Alexander Nezlobin

Alexander Nezlobin

London School of Economics & Political Science (LSE) - London School of Economics

Madhav V. Rajan

Booth School of Business, University of Chicago

Stefan J. Reichelstein

Stanford University - Stanford Graduate School of Business; CESifo (Center for Economic Studies and Ifo Institute)

Date Written: March 24, 2016

Abstract

We examine the structural properties of a firm's price-to-earnings (P/E) and price-to-book (P/B) ratios and the relation between these two ratios. A benchmark result is obtained under the hypothesis that firms use replacement cost accounting to value their operating assets, so that the P/B ratio coincides with Tobin's q. The firm's P/E ratio can then be expressed as a convex combination of the P/E ratios suggested respectively by the permanent earnings model and the Gordon growth model, with the relative weight to be placed on these two endpoints determined entirely by Tobin's q. Under current financial reporting rules, the accounting for operating assets is likely to be more conservative than replacement cost accounting. Our findings characterize how the magnitude and behavior of the P/E and P/B ratios are jointly shaped by several key variables, including both past and anticipated future growth, economic profitability, and accounting conservatism.

Keywords: price-to-earnings, price-to-book, Tobin's q, growth, profitability, conservatism

Suggested Citation

Nezlobin, Alexander and Rajan, Madhav V. and Reichelstein, Stefan J., Structural Properties of the Price-to-Earnings and Price-to-Book Ratios (March 24, 2016). Review of Accounting Studies, Forthcoming, Available at SSRN: https://ssrn.com/abstract=2754772

Alexander Nezlobin (Contact Author)

London School of Economics & Political Science (LSE) - London School of Economics ( email )

United Kingdom

Madhav V. Rajan

Booth School of Business, University of Chicago

1101 East 58th Street
Chicago, IL 60637-1561
United States

Stefan J. Reichelstein

Stanford University - Stanford Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States
650-736-1129 (Phone)
650-725-7979 (Fax)

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

HOME PAGE: http://www.CESifo.de

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