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Review of Accounting Studies

, Volume 21, Issue 2, pp 438–472 | Cite as

Structural properties of the price-to-earnings and price-to-book ratios

  • Alexander Nezlobin
  • Madhav V. Rajan
  • Stefan Reichelstein
Article

Abstract

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

Keywords

Price-to-earnings Price-to-book Tobin’s q Growth Profitability Conservatism 

JEL Classification

M41 L25 G11 

Notes

Acknowledgments

We are grateful to Tim Baldenius, Nicole Johnson, Stephen Penman, and seminar participants at UC Berkeley, UCLA, and the 2014 Colorado Summer Accounting Research Conference for their helpful comments on this paper. Particular thanks to James Ohlson, Russell Lundholm (editor), and an anonymous reviewer for their many constructive and detailed suggestions.

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Copyright information

© Springer Science+Business Media New York 2016

Authors and Affiliations

  • Alexander Nezlobin
    • 1
  • Madhav V. Rajan
    • 2
  • Stefan Reichelstein
    • 2
  1. 1.Haas School of BusinessUniversity of CaliforniaBerkeleyUSA
  2. 2.Graduate School of BusinessStanford UniversityStanfordUSA

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