Combining Earnings and Book Value in Equity Valuation
53 Pages Posted: 5 Nov 1997
Date Written: July 1997
It is common to apply multipliers to earnings and book value to calculate approximate equity values. However, applying a price-earnings multiple or a price-to-book multiple typically produces two valuations and the analyst is left with the question of how to combine these into one valuation. This paper calculates weights that do this. It shows that these weights differ over the difference between earnings and book value and systematically so over time: when earnings are small compared to book value the weights are different from when earnings are large relative to book value, and they vary in a non-linear way over the difference between the two. The weights have the interpretation of combining forecasts of future earnings based on earnings and book value separately into one composite forecast that uses both pieces of information together. So the paper calculates a second set of weights to ascertain how the two numbers are combined to forecast one-year-ahead earnings and three-years-ahead earnings. The calculated weights are applied out of sample to ascertain their predictive ability against other benchmarks.
JEL Classification: G12, M41
Suggested Citation: Suggested Citation