CFA Level II ExamEquity InvestmentsMedium
An equity analyst is comparing 'HealthCare Solutions Inc.' (HCS), a mature pharmaceutical company, with 'BioGen Innovations' (BGI), a rapidly growing biotechnology startup. Both companies are publicly traded. The analyst notes that HCS has a significantly lower Price-to-Book (P/B) ratio than BGI. Which of the following factors is most likely contributing to HCS's lower P/B ratio compared to BGI?
- AHCS has a higher dividend payout ratio.
- BHCS has a higher required rate of return (r).
- CHCS has a higher expected return on equity (ROE).
- DHCS has higher future growth opportunities.
Show answer & explanationAnswer & explanation
Correct answer: B. HCS has a higher required rate of return (r).
A lower P/B ratio is generally associated with lower expected growth, lower ROE, or a higher required rate of return (higher risk). Given that HCS is a mature company compared to a rapidly growing startup (BGI), it's less likely to have higher growth or ROE. A higher required rate of return (r) for HCS (perhaps due to perceived operational inefficiencies or industry-specific risks not offset by growth) would lead to a lower P/B ratio.
Why the other options are wrong
- A. A higher dividend payout ratio, while potentially impacting growth, is not the most direct or primary driver for a lower P/B ratio compared to the fundamental factors of growth, ROE, and required return.
- C. A higher expected ROE, especially if greater than the required return, would typically lead to a *higher* P/B ratio, not lower.
- D. Higher future growth opportunities would typically lead to a *higher* P/B ratio, not lower.
Drivers of P/B Ratio
The Price-to-Book (P/B) ratio is influenced by a company's expected return on equity (ROE), its required rate of return (r), and its expected future growth rate.
- Higher ROE generally leads to higher P/B.
- Higher growth generally leads to higher P/B.
- Higher required return (r) generally leads to lower P/B.
Memory trick: P/B is Driven by ROE, Risk, and Growth.