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
Review of Accounting Studies – Springer Journals
Published: Apr 8, 2016
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