CFA Level IEquity InvestmentsMedium
An analyst estimates that a company has a return on equity (ROE) of 12%, an expected long-term growth rate of 4%, and a required rate of return on equity of 10%. Using the fundamental (Gordon Growth-based) approach, what is the company's justified price-to-book (P/B) ratio?
- A2.00x
- B0.80x
- C1.33x
- D1.20x
Show answer & explanationAnswer & explanation
Correct answer: C. 1.33x
The justified P/B ratio is calculated as (ROE − g) / (r − g) = (0.12 − 0.04) / (0.10 − 0.04) = 0.08 / 0.06 = 1.33x.
Why the other options are wrong
- A. Incorrect; this overstates the ratio by using an incorrect denominator such as (r−g) doubled.
- B. Incorrect; this would result from inverting the ratio or a calculation error.
- D. Incorrect; this results from using ROE/r without subtracting growth, an incomplete formula.
Justified P/B Ratio
The fundamental price-to-book ratio derived from the Gordon Growth Model, calculated as (ROE − g) / (r − g), reflecting how much investors should pay per dollar of book value based on profitability, growth, and required return.
- Formula: Justified P/B = (ROE − g) / (r − g)
- Higher ROE relative to required return increases justified P/B
- Comparing justified P/B to actual market P/B indicates over/undervaluation
Memory trick: Profit power minus growth, over cost of capital minus growth.