P/E, P/B and the Present Value of Future Dividends

doi:10.2469/faj.v50.n4.23

Patricia M. Fairfield

The dividend discount model (DDM) is of limited use as a valuation tool because of the restrictive assumptions it makes about dividend payout policy. But the DDM can be restated directly in terms of accounting information, with no assumption of a fixed relation between accounting data and future dividends, and with no restrictions on payout policy. The resulting model focuses on the estimation of future profitability as the fundamental determinant of firm value. Book value and earnings have distinct roles in this model. It starts with book value--the stock of (net) assets--adjusting it upward or downward to reflect the expected profitability of those assets. The price/earnings ratio (P/E) is a function of expected changes in future profitability, and the price/book ratio (P/B) is a function of the expected level of future profitability. The model predicts that P/B should correlate positively with future return on book value, and that P/E should correlate positively with growth in earnings. Together, the ratios reveal information about expected future profitability relative to current profitability. The evidence supports the model and indicates that different P/E-P/B combinations are associated with distinct patterns of future profitability.

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