Interpreting Market-to-Book Ratios.
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Interpreting Market-to-Book Ratios. Exhibit 14.10 presents data on market-to-book (MB) ratios, ROCE, the cost of equity capital, and price-earnings (PE) ratios for seven pharmaceutical companies. (Note that PE ratios for these firms typically fall in the 30-3530−35 range.) Exhibit 14.10 also provides historical data on the five-year average rate of growth in earnings and dividend payout ratios for each firm. The data on excess earnings years represent the number of years that each firm would need to earn a rate of return on common shareholders’ equity (ROCE) equal to that in Exhibit 14.10 in order to produce value-to-book ratios that equal the market-to-book ratios shown. For example, Bristol-Myers Squibb would need to earn an ROCE of 48.9 \%48.9% for 58.3 years in order for the present value of the excess earnings over the cost of equity capital to produce a value-to-book ratio that matches the market-to-book ratio of 13.9 .13.9. REQUIRED Assume that market share prices for each firm are reasonably efficient. That is, do not simply assume that the market has over- or undervalued these firms. Considering the theoretical determinants of the market-to-book ratio, discuss the likely reasons for the relative ordering of these seven companies on their market-to-book ratios. |
Verified Answer
Company B has the greatest market-to-book ratio, this is because of the highest ROCE. The high dividend payout ratio results in an increase in the number of years needed to earn the average industry returns. The company's price-earnings ratio is similar to other firms and the average of the industry which indicates that there are very less capital or short-term gains or losses.
Company WL's market-to-book ratio is also high but because of the less growth in earnings, the ROCE is lower. Higher than the average price-earnings ratio indicates that the current ROCE is understated because the earnings include some short-term losses.
The market-to-book ratio of company E is high even when the ROCE is lower than other firms. A higher cost of equity resulted in lesser ROCE. Higher than the average price-earnings ratio indicates that the current ROCE is understated because the earnings include some short-term or transitory losses.
P's market-to-book ratio is average. But the ROCE is more than the cost of equity capital which indicates that the ratio must be higher than the actual one. The price-earnings ratio is quite near to the industry average which depicts that the company earns stable earnings and there are not many transitory gains or losses.
Company A's market-to-book ratio is the second highest because of the less number of years and higher ROCE. However, the price-earnings ratio is less as a result of positive transitory items or short-term gains included in the earnings.
M's market-to-book ratio is low because of the lesser ROCE and higher cost of equity capital. Lower ROCE is due to the more years needed to earn.
Company W's market-to-book ratio is the lowest of all the other firms. The low ROCE, high dividend payout ratio, low growth rate and less price-earnings ratio. The lesser price-earnings ratio indicates that the earnings include some transitory gains.
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