Question

Question 2. Chap 7 Discussion Question 5 (p.252) What types of companies have: a. a high P/E ratio and a low market-to-book ratio? b. a high P/E ratio and a high market-to-book ratio? c. a low P/E ratio and a high market-to-book ratio? d. a low P/E ratio and a low market-to-book ratio?

Answer 1

P/E ratio is the ratio of market price to earnings of the firm and is generally a indicator of the markets perception of growth potential of the firm.

Market to book ratio is the ratio market price to the book value of the share price of the firm. Book value is used to signify the value of stock in liquidation.

A. A high P/E and a low market to book ratio: Stocks in high growth industries where the high market expectations increases the momentum of price movement and thus spikes the price of the stock comes under this segment. Low market to book when P/E is high signifies that the earnings is low and book value is high (signifying large cap industries). Thus the industries here are large cap industries with huge momentum and high market expectations of growth.

B. A high P/E and a high market to book ratio: This are companies with high market expectations causing market price increase with low book value (probably medium or small cap I duatry). Typically internet technologies come under this segment.

C. A low P/E and a high market to book ratio: Low P/E signifies low market price even with high earnings signifying that market is not very positive towards this stock. A high market to book ratio is due to low book value typically for small cap companies.

D. A low P/E and a low market to book ratio:Low P/E signifies low market price signifying that market is not very positive towards this stock and there us no demand. A low market to book ratio is due to low price and high book value typically for large cap companies in capital good industries like EPC etc.