On (r, g) and the Identity ROE = EP*MTB

42 Pages Posted: 3 Feb 2021

See all articles by James A. Ohlson

James A. Ohlson

Hong Kong Polytechnic University - School of Accounting and Finance

Sophia Weihuan Zhai

Hong Kong Polytechnic University - School of Accounting and Finance

Date Written: December 2, 2020

Abstract

The paper concerns concepts of equity valuation. Three primary financial ratios -- (forward) return on equity (ROE), (forward) earnings to price ratio (EP), and the (current) market-to-book ratio (MTB) – are connected to the standard valuation parameters, r = cost of equity (discount factor), and g = growth. The framework relies on a Gordon-Williams type of PVD model and combines it with an add-on steady-state growth requirement: Subject to clean surplus accounting, (the expected) earnings, dividends, and book values all grow at the same rate. This condition is adapted from “The Second Fundamental Law of Capitalism”, articulated by Piketty (2014). Applying these ideas result in a benchmark model: (i) a weighted average representation, EP = BTM*r + (1- BTM) *Div.Yield , and (ii) the inequalities 0 < BTM < 1 and Div.Yield < EP < r < ROE. Additional analysis relaxes the steady-state growth condition: the g-parameter is now replaced by forecasts of near future earnings growth which get updated as time passes. An empirical part of the paper evaluates whether the steady-state growth concept holds as an average for S&P 500 firms. Results are generally supportive.

JEL Classification: G12, M41

Suggested Citation

Ohlson, James A. and Zhai, Sophia Weihuan, On (r, g) and the Identity ROE = EP*MTB (December 2, 2020). Available at SSRN: https://ssrn.com/abstract=3741088 or http://dx.doi.org/10.2139/ssrn.3741088

James A. Ohlson

Hong Kong Polytechnic University - School of Accounting and Finance ( email )

M715, Li Ka Shing Tower
Hung Hom, Kowloon
China

Sophia Weihuan Zhai (Contact Author)

Hong Kong Polytechnic University - School of Accounting and Finance ( email )

Hung Hom
Kowloon
Hong Kong

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
64
Abstract Views
291
rank
404,493
PlumX Metrics