{"id":19117,"date":"2021-08-04T15:18:00","date_gmt":"2021-08-04T15:18:00","guid":{"rendered":"https:\/\/analystprep.com\/study-notes\/?p=19117"},"modified":"2024-04-11T13:03:36","modified_gmt":"2024-04-11T13:03:36","slug":"describe-cyclical-effects-on-valuation-multiples","status":"publish","type":"post","link":"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/describe-cyclical-effects-on-valuation-multiples\/","title":{"rendered":"Valuation Multiples"},"content":{"rendered":"\r\n<p><iframe loading=\"lazy\" src=\"\/\/www.youtube.com\/embed\/NFyA0qXHhww\" width=\"611\" height=\"343\" allowfullscreen=\"allowfullscreen\"><\/iframe><\/p>\r\n<p>Valuation multiples include the <strong>price-to-earnings ratio<\/strong> (P\/E) and the <strong>price-to-book ratio<\/strong> (P\/B). A high P\/E ratio implies an expected high growth of a company&#8217;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&#8217;t be willing to pay a higher price for such a share, i.e., one that won&#8217;t yield meaningful returns. The market, status of the economy, sector, or the specific company are the factors that influence the P\/E ratio.<\/p>\r\n<p>The P\/B indicates the extent to which a company&#8217;s net assets cover the value of its shares. Moreover, it shows the strength of an investors&#8217; expectations on a company&#8217;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.<\/p>\r\n<p>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.<\/p>\r\n<p>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.<\/p>\r\n<blockquote>\r\n<h2>Question<\/h2>\r\n<p>When is the price-to-book ratio <em>most likely<\/em> to increase, holding all else constant?<\/p>\r\n<p>When:<\/p>\r\n<ol type=\"A\">\r\n\t<li>Real interest rates increase.<\/li>\r\n\t<li>Expected future earnings growth increase.<\/li>\r\n\t<li>Expected inflation increases.<\/li>\r\n<\/ol>\r\n<h4><strong>Solution<\/strong><\/h4>\r\n<p><strong>The correct answer is B.<\/strong><\/p>\r\n<p>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.<\/p>\r\n<\/blockquote>\r\n<p>Reading 43: Economics and Investment Markets<\/p>\r\n<p><em>LOS 43 (j) Describe cyclical effects on valuation multiples.<\/em><\/p>\r\n","protected":false},"excerpt":{"rendered":"<p>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&#8217;s earnings in the future. Therefore, investors will be more willing to pay a higher price for&#8230;<\/p>\n","protected":false},"author":4,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[102,473],"tags":[216,564],"class_list":["post-19117","post","type-post","status-publish","format-standard","hentry","category-cfa-level-2","category-portfolio-management","tag-cfa-level-2","tag-portfolio-management","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v27.4 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Valuation Multiples - CFA, FRM, and Actuarial Exams Study Notes<\/title>\n<meta name=\"description\" content=\"Understand the relationship between valuation multiples like the P\/E ratio and P\/B ratio with real earnings growth and real interest rates.\" \/>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/describe-cyclical-effects-on-valuation-multiples\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Valuation Multiples - 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