Equity Valuation Using Multiples: An Empirical Investigation

Theoretical foundations 37and, eventually, divide both sides of the equation (3.28) by B tto receive theintrinsic P/B multiple at time tequity( ROCE − t+ 1r )equity B equity( − ) ⋅ ( 1+)equityvt= 1+B r g rt(3.29)Equation (3.29) shows that a firm’s P/B multiple is a function of its expectedprofitability, measured by ROCE, its risk, measured by the cost of equity, and itsgrowth (in book value of equity). Also, note that if a firm is expected to earn zeroequityresidual income in the future (i.e., ROCE1− r = 0 ), its intrinsic P/B multiple ist+ equityone (i.e., v / B = 1) and thus the firm is worth exactly its current book value ofttequity. Penman (1996) refers to this benchmark case as the “normal” P/B multiple.Any premium to the book value of equity, at which a firm trades, is attributable toexpected non-zero residual income and growth in book value. Thus, the P/B multipleis a useful measure to get a quick impression of what the market thinks aboutthe key value drivers of a firm: growth, profitability, and risk.When comparing the fundamental determinants of the P/E and the P/B multiple,we find that both of them depend on the risk of a firm, measured by its cost ofequity. However, the P/E multiple is mainly driven by future earnings growth,whereas the major drivers of the P/B multiple are future ROCE and growth in bookvalue of equity (Penman 1996, p. 256). Given the importance of the P/B multiple inthe financial industry and its underlying drivers, we might understand why executivesof many banks tend to worry more about being profitable and becoming “big”than focusing solely on earnings (growth) as it is common in other industries, especially,of course, in growth industries.