Valuation Multiples

Valuation multiples include the price-to-earnings ratio (P/E) and the price-to-book ratio (P/B). A high P/E ratio implies an expected high growth of a company’s earnings in the future. Therefore, investors will be more willing to pay a higher price for such a share. A low P/E ratio relative to the market implies a low growth prospect. Under such circumstances, investors won’t be willing to pay a higher price for such a share, i.e., one that won’t yield meaningful returns. The market, status of the economy, sector, or the specific company are the factors that influence the P/E ratio.

The P/B indicates the extent to which a company’s net assets cover the value of its shares. Moreover, it shows the strength of an investors’ expectations on a company’s capacity to generate high returns, on its net assets, adjusted for risk. The higher the P/B ratio, the greater the expectations for growth, but the lower the safety margin if things do not turn out as expected. As is the case with the P/E ratio, the market, sector, and stock in question determine what makes up a high/low P/B ratio.

In conclusion, P/E and P/B ratios have a positive relation to real earnings growth. At the same time, they have a negative relation to real interest rates. This is attributable to declining volatility in real GDP growth, expected inflation, uncertainty about future inflation, and equity risk premium.

During periods of economic growth, both P/E and P/B ratios rise while equity risk premium declines. All these elements are influenced by the business cycle.

Question

When is the price-to-book ratio most likely to increase, holding all else constant?

When:

1. Real interest rates increase.
2. Expected future earnings growth increase.
3. Expected inflation increases.

Solution

The correct answer is B.

Price-per-book ratio is positively correlated with expected earnings growth rates and negatively correlated to required returns. Therefore, the price-to-book ratio will rise with increases in expected future earnings growth and with a decrease in the real rate, expected inflation, the risk premium for inflation uncertainty, or the equity risk premium.

Reading 43: Economics and Investment Markets

LOS 43 (j) Describe cyclical effects on valuation multiples.