CFA Level II ExamEquity InvestmentsEasy
A financial analyst is evaluating 'Global Manufacturing Inc.', a publicly traded company. The analyst notes that Global Manufacturing has a significantly lower Price-to-Book (P/B) ratio compared to its industry peers. All else being equal, which of the following factors would most likely explain Global Manufacturing's lower P/B ratio?
- ALower financial leverage.
- BHigher expected future earnings growth.
- CHigher return on equity (ROE).
- DHigher cost of equity.
Show answer & explanationAnswer & explanation
Correct answer: D. Higher cost of equity.
The P/B ratio is inversely related to the cost of equity, assuming other factors like ROE and growth are constant. A higher cost of equity implies a higher discount rate for future earnings, reducing the present value of equity and thus the P/B ratio.
Why the other options are wrong
- A. Incorrect. Lower financial leverage, all else equal, might imply lower risk and thus a lower cost of equity, potentially leading to a higher P/B ratio.
- B. Incorrect. Higher expected future earnings growth would generally lead to a higher P/B ratio, not lower.
- C. Incorrect. A higher return on equity (ROE) would typically result in a higher P/B ratio, as it indicates better profitability relative to book value.
Drivers of P/B Ratio
Factors that influence a company's Price-to-Book (P/B) ratio, primarily return on equity, growth rate, and cost of equity.
- P/B = (ROE - g) / (r - g) (simplified relation).
- Higher ROE generally leads to higher P/B.
- Higher cost of equity (r) generally leads to lower P/B.
Memory trick: P/B is driven by Returns, Growth, and Cost.