Capital Investments and Financial Ratios

Capital Investments and Financial Ratios

By Madhav V. Rajan, Stefan J. Reichelstein, Alexander Nezlobin
April 2014Working Paper No. 3052
We examine a firm’s price-to-earnings (P/E) and price-to-book (P/B) ratios in a model of sequential capacity investments. Our analysis focuses on several key variables, including past and anticipated future investment growth, economic profitability and accounting conservatism, which jointly shape the magnitude and behavior of the two ratios. We obtain a benchmark result under the hypothesis that firms use replacement cost accounting to value their operating assets. The P/B ratio then coincides with Tobin’s q and the firm’s P/E ratio can be expressed as a convex combination of the P/E ratios suggested respectively by the permanent earnings model and the Gordon growth model. The relative weight to be placed on these two endpoints is captured entirely by Tobin’s q. Relative to this benchmark result, we analyze the behavior of both ratios when the applicable accounting rules are more conservative than replacement cost accounting.