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SYMBOLS USED
In this article, certain letters are used consistently
to represent words and ratios, as follows:
F
E
B
A
P/B
P/E
E/B
AE = Dividend
The earlier article presented the formula:
P/B - P/E X E/B,
where P/E is the price/earnings ratio, but may also
be used in the sense of a multiplier. When P/E is
used in the sense of a multiplier, E/B represents
underlying profitability rather than merely current
earnings.
The price to book value ratio is important
because it draws together the external and internal
factors of price, completing the cycle of market and
company analysis, for the price/earnings ratio is
the stock market aspect of a company and the
return on equity is the stockholder's vindication.
This article attempts to examine some of the relationships between profitability (E/B), the P/E ratio,
growth, volatility of earnings, etc., and to discuss
the peculiar behavior of P/E ratios. The study of
these factors may tell us something about P/B, or
the price paid for book value.
Reprinted from Financial Analysts Joumal (September/October
1964):108-17.
in
the
Financial Analysts
Journal by
63
1955-1964
THE "U" CHARACTERISTIC
64
1955-1964
Rgure 1. TTiirty DouKJones Industrial Average Stocks Average Rgures,
1949-1962
B
_
20
AA
ACD
UK /
DD
: / '
10
CM
1
10
20
E/B
C
20
. '
'
10
200
20
40(1
F/B
10
20
E/B
profitability line. If profitability falls, they are protected by assets and cling to the constant P/B
curve.
65
1955-1964
A STUDY OF THE DOW-OONES
Table 1. Selected Statistics for 30 Dow^ones Industriai Average Stocks Average Figures, 1949-1962
GM
DD
GE
UK
N
GF
EK
PG
S
TX
SD
OI
UA
GT
J
AT
IP
JM
ACD
AA
BS
C
AC
Z
X
wx
T
HR
A
SWX
66
Percent
Earned
on
Equity
Price
to
Book
Ratio
Price/
Earnings
Ratio
Earnings
Book Value
E/B
P/B
P/E
G,
Gt,
22.5%
19.7
18.7
16.9
16.6
16.5
15.9
15.1
14.8
14.4
14.2
14.1
13.5
13.4
13,3
12.8
12.8
12.2
12.0
11.5
10.9
10.6
10.3
2.52
4.14
3.65
3.51
2.58
2.62
3.16
2.55
2.08
1.50
1.43
2.10
1.56
1.50
1.58
1.45
1.72
1.62
2.22
2.52
1.01
1.26
1.49
1.46
1.10
1.41
1.27
0.78
0.67
0.70
11.2
21.0
19.5
20.8
15.6
16.9
19.9
16.9
14.8
11.3
10.1
15.6
11.5
11.3
11.8
11.3
13.5
13.2
18.5
22.0
4.7%
9.4%
4.9
4.1
2.8
6.0
8.4
8.6
6.8
4.9
7.6
8.8
2.6
0.1
7.6
4.3
3.2
0.4
8.0
7.9
6.0
7.0
9.9
9.4
8.7
8.5
7.4
6.3
5.0
9.2
11.8
14.4
14.8
11.7
16.2
14.9
10.6
10.6
14.1
-1.2
1.2
1.8
-1.5
-9.6
-1.0
2.7
1.3
-3.3
3.7
-2.5
-0.9
-1.4
8.0
7.5
7.8
7.8
9.5
5.8
4.9
8.1
9.5
8.6
4.8
7.9
5.2
Instability
Index
Dividend
Payout
Ratio
A
102%
64
57
52
83
50
28
35
33
15
11
67
138
15
38
46
68
3.8
8.1
6.2
4.6
4.2
96
67
108
120
364
70
4.7
4.5
3.2
2.2
4.5
1.9
1.0
180
222
9
135
180
212
33
65%
78
63
70
66
54
56
58
53
37
44
m
60
37
57
62
49
64
63
41
59
64
m
57
61
71
60
67
79
1955-1964
(E/B) on the price/earnings ratio. None of the
stocks averaged a price to book ratio below 0.67
over the period 1949-62. A statistically significant
linear relationship existed between profitability
and the price/earnings ratio, although it was poor.
If three stocks are ignored, Alcoa, Allied Chemical,
and General Motors, there is a hint of a "U"
characteristic curve. Such a curve, roughly drawn,
is shown on the chart as a broken line.
It is the existence of this "U" plus some of the
longer term counter movements which prevent a
good "straight line" statistical relationship between P/E and E/B. If we eliminate stocks of very
low profitability and high earnings instability, the
relationship between P/E and E/B offers a wellbehaved linear pattern.
The refusal of General Motors, Alcoa and
Allied Ghemical to follow the "U" curve closely
can be explained better by the pattern of price/
earnings ratios in their respective industries than
by the factors covered in this study. This matter is
most complex and must be treated in a separate
article. However, the reader will note in Figure 1-B
that General Motors sold at roughly the same P/E
ratio as Chrysler and that Allied Chemical's P/E
ratio was near that of the other tM,'o chemicals
despite substantial differences in the levels of profitability. Similarly, Table I shows a tendency for
the P/E ratios in other industries to fall in a narrow
range.
The influence of profitability on price/earnings
ratios is slightly exponential because of the impact
of profitability on growth. Price/earnings ratios are
greatly influenced by expectations of growth. Eigure 1-C shows (E/B)^ plotted against P/E. Here
again the linear relationship was mediocre, but
statistically significant, and the "V" curve slightly
more pronounced than in Figure 1-B.
Eigure 1-D reveals that earnings instability
and profitability do not appear to have a linear
relationship. The cause and effect dilemma raises
questions about the instability index. It is clear that
high profitability is associated with a strong resistance to earnings declines.
No graphs are shown plotting earnings instability and payout against the price/earnings ratio.
However, such graphs merely show that the relationship is poor, and that stocks with highly volatile earnings are likely to be found in the low P/E
group. There is a fine statistical relationship between P/E and the instability index expressed as a
third-degree parabola, but this may be merely a
mathematical oddity. The important influence of
payout on the price/earnings ratio is badly blurred
67
1955-1964
Rgure 2.
10
A(E/B)
20
-10
20
E/B
68
E/B
1955-1964
Rgure 3. Thirty Dow-Jones Industrial Average Stocks, 1949-1962
40.0
GM
DD
UK
G E .
20.0
10.0
5.0
2.0
1.0
0.5
78
65
70
63
66
40.0
SD
OI
GT
UA ,
20.0
10.0
5.0
2.0
1.0
0.5
44
57
40.0
BS
AC
20.0
10.0
5.0
2,0
1.0
0.5.
62
64
Payout (%)
E/B
P/E
P/B
68
'57
1955-1964
Rgure 3.
GF
EK
PG
TX
20, tl
10.0
5.0
2.0
1.0
0.5
54
56
53
58
37
40.0
AT
IP
JM
AGD
AA
20.0
A./ ; \
10.0
5.0
2.0
1.0
03
40.0
62
64
T
wx ..
63
HR
41
A
swx
20.0
10.0
5.0
2.0
60
1.0
0.5,
71
Payout (%)
E/B
P/E
P/B
67
79
1955-1964
good examples of stocks on a constant P/B
line, near the liquidation level. Certain
other stocks followed constant P/B lines
which were probably related to the hopefully better earnings which might exist in a
more obliging environment. The P/B ratio
of all of these stocks failed to participate in
the general upward trend of P/B ratios.
5. The P/E ratio and the resulting P/B ratio
were depressed by earnings instability and
low payout and elevated by stable earnings
and high payout.
6. The twelve stocks with the best growth in
earnings per share (See Table 1) were all
found to be among the top 15 in profitability.
7. The stocks having the least earnings stability were largely found in the least profitable
group.
8. Certain stocks consistently sold at much
lower or higher prices than could be explained by Figure 3 or by statistical analysis
of the factors in Table 1. Examples are
Texaco, Standard Oil of California and
General Motors among the apparently
cheap stocks, and Alliecl Chemical, Alcoa
and Westinghouse among those overpriced.
9. The ratio of price to book value moved
more slowly than P/E or E/B, revealing in
an orderly manner the market's changing
appraisal of the value of each company's
equity.
The final figure (Figure 4) shows the action of
P/E and E/B as indexes relative to the comparable
DJIA ratios. The P/B index is not shown, but its
trends and variations can be approximated by
visualizing a line half way between the P/E and the
P/B indexes.
Figure 4 shows clearly that stocks which "beat
the Dow" in profitability level also beat the Dow in
price/earnings ratios.
1. The counter movement continued to appear even after the influence of the market
was removed. GM is a marvelous "mirror
image"!
2. The price/earnings index of the more profitable stocks generally had an upward
trend, while the P/E trend of the less fortunate stocks was unfavorable. This probably
reflected the increasing emphasis on
"growth" stocks in the latter years of the
period studied.
71
1955-1964
Rgure 4.
DJTA - 1 0 0
300
GM
DD
GE
200
100
50
200
G F
TX
PG.. . '
100
60
200
UA "
SD
GT
100
50
200
IP
ACD
JM
100
50
200 _
BS
AC
100
50
20
200
WX
HR
SWX
100 -.
50
25
E/B
P/E
1955-1964
FOOTNOTES
1. F.E. Block, "The Place of Book Value in Common Stock
Evaluation," financial Analysts Journal (March/April 1964):
29-33.
2. N. Moiodovsky, "A Theory of Price-Earnings RaHos," The
Analysts journal (November 1953):65-80.
3. See S.F. Nicholson, "Price-Earnings Ratios," Financial Analysts Journal (July/August 1960):43-45.
4. M. Kisor, Jr., "The Financial Aspects of Growth," Financial
Analysts Journal (March/April 1964):46-51.
73