1955-1964

A Study of the Price to Book Relationship

Frank E. Block

n an earlier article, the author developed an

argument in favor of greater consideration of
book value in common stock analysis.^ It was and
is believed that effectively used assets are the basis
of profitability, growth, dividends and certain
other factors which establish value. Without an
adequate understanding of the ways in which
assets and profitability interact upon each other,
the valuation process becomes exceedingly difficult.

THE PRICBEARNINGS RATIO

Attention must first be directed to two perverse
characteristics of the price/earnings ratiothe well
known "counter movement" of price/earnings ratios, and the "U" characteristic. These two factors
account heavily for what often seem to be completely irrational movements in price/earnings ratios.

SYMBOLS USED
In this article, certain letters are used consistently
to represent words and ratios, as follows:

THE COUhTTER MOVEMENT

The counter movement principle as first introduced by Nicholas Molodovsky in 1953 in the

F
E
B
A
P/B
P/E
E/B

Financial Analysts Journal (then The Analysts Jour-

= Price per share

= Earnings per share
= Book value per share
= Dividend payout ratio
= The ratio of price to book value
The price/earnings ratio, or "multiplier"
= Return on equity, or "profitability"

AE = Dividend
The earlier article presented the formula:
P/B - P/E X E/B,
where P/E is the price/earnings ratio, but may also
be used in the sense of a multiplier. When P/E is
used in the sense of a multiplier, E/B represents
underlying profitability rather than merely current
earnings.
The price to book value ratio is important
because it draws together the external and internal
factors of price, completing the cycle of market and
company analysis, for the price/earnings ratio is
the stock market aspect of a company and the
return on equity is the stockholder's vindication.
This article attempts to examine some of the relationships between profitability (E/B), the P/E ratio,
growth, volatility of earnings, etc., and to discuss
the peculiar behavior of P/E ratios. The study of
these factors may tell us something about P/B, or
the price paid for book value.
Reprinted from Financial Analysts Joumal (September/October
1964):108-17.

Financial Analysts Journal / January-February 1995

nal).^ His subsequent writings on related topics

provided amplification of this phenomenon. Without question, Molodovsky's counter movement
principle was a major breakthrough which provided analysts with their first clear insight into the
behavior of price/earnings ratios.
The counter movement is the tendency of
price/earnings ratios to move in the opposite direction from earnings. If earnings deviate from the
level considered to be "normal" by the market, the
price/earnings ratio merely adjusts itself to a level
which will leave the market price unchanged,
except to the extent that other influences enter the
picture. Thus, it is clear that price is more closely
related to "normal earnings," "average earnings,"
"basic earning power," "intrinsic value'/' etc.,
than to temporary earnings deviations within an
expectable range of fluctuations. If the fluctuation
in earnings exceeds the market's expectation and
is, therefore, uncharacteristic of what the market
considers normal, it is probable that the stock will
be reappraised by the market immediately and
new standards of normalcy will be established.
While the counter movement has been well
covered

in

the

Financial Analysts

Journal by

Molodovsky and others, many security analysts

persist in making recommendations based on projections of current or "next year's" earnings, without regard to whether those earnings are merely
normal cyclic fluctuations or a change in the underlying earrung power of the company.

63

1955-1964
THE "U" CHARACTERISTIC

Less familiar is what the author calls the "U"

characteristic. If the reader will refer to Figure 1-A
the following discussion may be somewhat clearer.
The "U" characteristic is a relationship of price to
basic earning power rather than to current earnings.
If earning power were the only criterion of
value, stocks with a return on equity (E/B) of zero
would have no value and the price/earnings ratio
(P/E) would be meaningless. Earnings multipliers
rise with expectations of growth. Since growth is
closely related to the return on equity, the price/
earnings ratio should rise when basic profitability
rises. This is shown in Figure 1-A as a broken line,
rising as E/B increases, and is called the profitability
line. There are reasons to think that this line should
be curved and concave upward, rather than a
straight line, as we shall see later.
The profitability line tends to have the greatest
influence on those companies whose earnings are
so large a part of the valuation picture as to
eliminate assets, per se, from consideration. Stocks
of low profitability tend to be influenced, increasingly as E/B declines, by assets. Thus, a second
broken line is shownthe constant price to book value

/mewhich intersects the profitability line. Some

stocks are influenced almost completely by the
constant P/B line.
The constant P/B line represents a market
valuation of stocks of below average or no profitability. The P/B constant for a given company will
depend on the composition of its assets, the possible value of those assets in a merger or liquidation, the earnings potential of the assets under an
improved management or less competitive conditions, the timing and likelihood of such developments, and so on. The degree of optimism or
pessimism in the stock market would also be an
important influence.
If all other characteristics of payout, earnings
instability, size, industry, quality, etc., were the
same, we would expect stocks to fall on son:ie line
such as the solid line in Figure 1-A. This curve is
shaped roughly like the letter "U". As profitability
declined, a stock would begin to reach a point at
which the influence of the constant P/B line would
overcome the influence of the profitability line.
Similar stocks of different profitability should provide a "U" shaped curve when P/E is plotted
against E/B, using average figures for a reasonably
long period of time.
The slope of the profitability line of a particu-

64

lar stock is influenced by quality, payout, growth,

cyclicality, and similar factors. The market provides us with a family of constant book value
curves crossed by a family of profitability lines.
Each combination of one constant book value line
and one profitability line constitutes a mathematical "class" of stocks which would have a particular
"U" curve. These curves are dynamic, changing
with market conditions. Thus, we should not expect all stocks to follow a single "U" curve nor a
single stock to adhere to a fixed "U" curve for a
long period of time.
When earnings undergo short term departures from their "normal" level, price/earnings
ratios react automatically, simply because the denominator has changed. Point "V" on the "U"
curve represents a stock which is valued in terms
of its earnings. In accordance with the counter
movement principle, the price/earnings ratio
should adjust in the directions of the small arrows
to reflect the temporary departures of earnings
from their norm.
Point "Q" represents a low profitability stock
and is found on the constant P/B portion of the
"U" curve. Such a stock will merely move up or
down the "U" curve with fluctuations in earnings
since the market appraises this stock almost entirely in terms of its assets. It will not depart from
the "U" curve as "V" will.
It should be noted that "V" moves up and
down a line which is somewhat similar to a constant P/B line. If "V's" earnings can be expressed
in terms of a fixed return on equity, then the
counter movement will be reflected in movements
up and down a fixed P/B linein essence, price
could be viewed either in terms of a multiplier of
earning power or as a capitalizer of the equity
assets which provided those earnings. The results
would be the same! However, in the rare case of a
"V" whose earnings are only loosely related to
assets, the counter movement should be expressed
in terms of price and earnings per share only.
The existence of the "\J" characteristic is helpful in explaining the anomaly that high price/
earnings ratios are often associated with very unprofitable companies, as well as with those which
are highly profitable. The low P/E stocks are those
which are associated with below average profitability, but have not yet moved up either the
constant price to book value line or the profitability
line. A number of studies, some of them using the
DJIA, have shown that the low P/E stocks regularly
outperform stocks with average or high price/
earnings ratios.^ The stocks at the bottom of the

Financial Analysts Journal / January-Febmary 1995

1955-1964
Rgure 1. TTiirty DouKJones Industrial Average Stocks Average Rgures,
1949-1962

B
_
20

AA
ACD

UK /

DD

: / '

10

CM

1
10

20
E/B

C
20

. '

'

10

200

20

40(1

F/B

10

20

E/B

"U" curve have nowhere to go but up in price/

earnings ratios. If the profitability base rises, such
stocks reward the investor by moving up the

Financial Analysts Joumal / January-February 1995

profitability line. If profitability falls, they are protected by assets and cling to the constant P/B
curve.
65

1955-1964
A STUDY OF THE DOW-OONES

The author has prepared a statistical study of the

30 stocks currently in the Dow-Jones Industrial
Averages, covering the years 1949-62. Those 14
years covered bear, bull, and intermediate markets, more than three full business cycles, and at
least one minor war. They should be representative of the postwar economy and its stock market
through 1962. Unless the Millennium has come,
we can expect the stock markets of the future to be
exposed periodically to similar developments. The
average figures are shown in Table 1. The 30 stocks
are listed in the order of their profitability (E/B).
To determine the relative instability of earnings, a simple index was devised, consisting of the
sum of all year-to-year percentage declines in earnings per share for each stock. (Standard deviation
is not the best measure of earnings instability,
since it is largely the downward movements in

earnings which give investors the cold horrors.

Upward fluctuations in earnings are borne with
exemplary fortitude by most investors.)
The results of the study are presented in four
series of figures. The first two series deal in average figures for the fourteen years. The two final
series of charts show the figures for individual
years. The relationships developed are based entirely on history. It is not intended to deprecate the
importance of expectationsfor most of any valuation process is oriented toward the future rather
than the past. This study must, therefore, be taken
in the context of market expectations, or valuations, as they existed in the pessimistic and optimistic markets of the years 1949 through 1962.
Those expectations are just as much a part of
history as the growth rates or dividend payouts of
that time span.
Figure 1-B shows the effect of profitability

Table 1. Selected Statistics for 30 Dow^ones Industriai Average Stocks Average Figures, 1949-1962

GM
DD
GE
UK
N
GF
EK
PG
S
TX
SD
OI
UA
GT

J
AT
IP
JM
ACD
AA
BS
C
AC
Z
X

wx

T
HR
A
SWX

66

Percent
Earned
on
Equity

Price
to
Book
Ratio

Price/
Earnings
Ratio

Earnings

Book Value

E/B

P/B

P/E

G,

Gt,

22.5%
19.7
18.7
16.9
16.6
16.5
15.9
15.1
14.8
14.4
14.2
14.1
13.5
13.4
13,3
12.8
12.8
12.2
12.0
11.5
10.9
10.6
10.3

2.52
4.14
3.65
3.51
2.58
2.62
3.16
2.55
2.08
1.50
1.43
2.10
1.56
1.50
1.58
1.45
1.72
1.62
2.22
2.52
1.01
1.26
1.49
1.46
1.10
1.41
1.27
0.78
0.67
0.70

11.2
21.0
19.5
20.8
15.6
16.9
19.9
16.9
14.8
11.3
10.1
15.6
11.5
11.3
11.8
11.3
13.5
13.2
18.5
22.0

4.7%

9.4%

4.9
4.1
2.8
6.0
8.4
8.6
6.8
4.9
7.6
8.8
2.6
0.1
7.6
4.3
3.2
0.4

8.0
7.9
6.0
7.0

9.9
9.4
8.7
8.5
7.4
6.3
5.0

9.2

11.8
14.4
14.8
11.7
16.2
14.9
10.6
10.6
14.1

Annual Growth Rate

1949-51 vs. 1960-62

-1.2
1.2
1.8

-1.5
-9.6
-1.0
2.7
1.3

-3.3
3.7

-2.5
-0.9
-1.4

8.0
7.5
7.8
7.8
9.5
5.8
4.9
8.1
9.5
8.6
4.8

7.9
5.2

Instability
Index

Dividend
Payout
Ratio
A

102%
64
57
52
83
50
28
35
33
15
11
67
138
15
38
46

68

3.8
8.1
6.2
4.6
4.2

96
67
108
120
364
70

4.7
4.5
3.2
2.2
4.5
1.9
1.0

180
222
9
135
180
212

33

65%
78
63
70
66
54
56
58
53
37
44

m
60
37
57
62
49
64
63
41
59
64

m
57
61
71
60
67
79

Financial Analysts Journal / January-February 1995

1955-1964
(E/B) on the price/earnings ratio. None of the
stocks averaged a price to book ratio below 0.67
over the period 1949-62. A statistically significant
linear relationship existed between profitability
and the price/earnings ratio, although it was poor.
If three stocks are ignored, Alcoa, Allied Chemical,
and General Motors, there is a hint of a "U"
characteristic curve. Such a curve, roughly drawn,
is shown on the chart as a broken line.
It is the existence of this "U" plus some of the
longer term counter movements which prevent a
good "straight line" statistical relationship between P/E and E/B. If we eliminate stocks of very
low profitability and high earnings instability, the
relationship between P/E and E/B offers a wellbehaved linear pattern.
The refusal of General Motors, Alcoa and
Allied Ghemical to follow the "U" curve closely
can be explained better by the pattern of price/
earnings ratios in their respective industries than
by the factors covered in this study. This matter is
most complex and must be treated in a separate
article. However, the reader will note in Figure 1-B
that General Motors sold at roughly the same P/E
ratio as Chrysler and that Allied Chemical's P/E
ratio was near that of the other tM,'o chemicals
despite substantial differences in the levels of profitability. Similarly, Table I shows a tendency for
the P/E ratios in other industries to fall in a narrow
range.
The influence of profitability on price/earnings
ratios is slightly exponential because of the impact
of profitability on growth. Price/earnings ratios are
greatly influenced by expectations of growth. Eigure 1-C shows (E/B)^ plotted against P/E. Here
again the linear relationship was mediocre, but
statistically significant, and the "V" curve slightly
more pronounced than in Figure 1-B.
Eigure 1-D reveals that earnings instability
and profitability do not appear to have a linear
relationship. The cause and effect dilemma raises
questions about the instability index. It is clear that
high profitability is associated with a strong resistance to earnings declines.
No graphs are shown plotting earnings instability and payout against the price/earnings ratio.
However, such graphs merely show that the relationship is poor, and that stocks with highly volatile earnings are likely to be found in the low P/E
group. There is a fine statistical relationship between P/E and the instability index expressed as a
third-degree parabola, but this may be merely a
mathematical oddity. The important influence of
payout on the price/earnings ratio is badly blurred

Financial Analysts Journal / January-February 1995

by overriding influences. Thus, these graphs were

not included.
Figure 1-E provides some interesting information on the price to book value relationship. Since
Figure 1-E plots P/B against E/B, one would think
that the book value figure, B, would cancel out and
the results would be the same as a graph of price
versus earnings. Actually, Figure 1-E rearranges
the position of the points on the graph, but not the
relationship of price to earnings. Thus, Figure 1-E
permits us to see that there is a good linear
relationship between P/B and E/B but that the
points follow more closely a curved line (slightly
concave upward, such as the roughly drawn broken line shown) than the solid straight line. This
curved line does not appear when P is plotted
against E, but is significant in indicating that the
P/B to E/B relationship is slightly exponential. This
should have been expected since P/B is the product
of E/B X P/E and P/E has already been shown to
bear a modest statistical relationship to E/B and
even to (E/Bf.
Figure 1-F shows that the influence of the paid
out (dividend) portion of earnings bears a good
relationship to price and that the relationship appears to be linear. This linearity is to be expected
since "paid out" earnings have no influence on
growth. It is the retained portion of earnings
which cause growthnot the paid out portion.
Figures 2-A and 2-B reveal that earnings and
dividends tend to control the ratio of price to book
value in individual years, 1949 in this case, as well
as over a span of years.
Figures 2-C and 2-D show clearly the strong
potency of profitability in determining the growth
of earnings and of book value. The sharp decline in
return on equity in the 1949-62 period prevented
actual earnings growth rates from equaling those
of book value. The growth in book value correlates
extremely well with the growth formula:**
Annual growth rate ^
(1 - payout) X (Return on equity)
This formula says, for example, that if a company earned 16 percent on equity and paid out
one-fourth of these earnings as dividends, book
value would rise by the remaining 12 percent. This
would permit a theoretical increase in earnings of
12 percent if the company could reinvest the retained earnings at the same 16 percent rate on
equity.
Figure 3 shows the individual records of each
of 30 DJIA stocks for the years 1949-62. The
graphs are plotted on a logarithmic scale. The price

67

1955-1964
Rgure 2.

DJIA Stocks and Annual Rates of Growth

30 DJIA Stocks, 1949

3

10
A(E/B)

20

DJIA Annual Rates of Growth, 1949-62

-10

20

E/B

to book ratio is shown as a heavy line, profitability

as a light line, and the P/E ratio as a dotted line. On
logarithmic paper, the P/B line is the sum of the
heights of the P/E and E/B lines, less two cycles
because E/B is expressed as a percentage rather
than a decimal figure. The number at the bottom of
each company chart is the average dividend payout ratio. The companies are identified by their
New York Stock Exchange symbols. The stocks are
placed in the order of their average E/B, starting
with the highest, GM, at the left top chart and
reading to the right.
Out of this jungle of apparently aimless lines a

68

E/B

few patterns can be discerned by the ir\dustrious

reader:
1. Ignoring for the moment the fluctuations of
individual years, a glance across the 30
figures will show a generally declining pattern of average P/E and P/B ratios as the
level of profitability declines.
2. The trends generally were downward for
E/B and, happily, upward for P/E and P/B
from 1949 to 1962.
3. The counter movement was especially
vivid for the more cyclic companies.
4. The three least profitable companies are

Financial Anaiysts Journai / January-February 1995

1955-1964
Rgure 3. Thirty Dow-Jones Industrial Average Stocks, 1949-1962
40.0

GM

DD

UK

G E .

20.0

10.0

5.0

2.0

1.0

0.5

78

65

70

63

66

40.0

SD

OI

GT

UA ,

20.0

10.0

5.0

2.0

1.0

0.5

44

57

40.0

BS

AC

20.0

10.0

5.0

2,0

1.0

0.5.

62

64
Payout (%)
E/B
P/E
P/B

68

'57

1955-1964
Rgure 3.

Thirty DownJones Industrial Average Stocks, 1949-1962

40.0

GF

EK

PG

TX

20, tl

10.0

5.0

2.0

1.0

0.5

54

56

53

58

37

40.0

AT

IP

JM

AGD

AA

20.0

A./ ; \
10.0

5.0

2.0

1.0

03
40.0

62

64
T

wx ..

63
HR

41
A

swx

20.0

10.0

5.0

2.0

60
1.0
0.5,

71
Payout (%)
E/B
P/E
P/B

67

79

1955-1964
good examples of stocks on a constant P/B
line, near the liquidation level. Certain
other stocks followed constant P/B lines
which were probably related to the hopefully better earnings which might exist in a
more obliging environment. The P/B ratio
of all of these stocks failed to participate in
the general upward trend of P/B ratios.
5. The P/E ratio and the resulting P/B ratio
were depressed by earnings instability and
low payout and elevated by stable earnings
and high payout.
6. The twelve stocks with the best growth in
earnings per share (See Table 1) were all
found to be among the top 15 in profitability.
7. The stocks having the least earnings stability were largely found in the least profitable
group.
8. Certain stocks consistently sold at much
lower or higher prices than could be explained by Figure 3 or by statistical analysis
of the factors in Table 1. Examples are
Texaco, Standard Oil of California and
General Motors among the apparently
cheap stocks, and Alliecl Chemical, Alcoa
and Westinghouse among those overpriced.
9. The ratio of price to book value moved
more slowly than P/E or E/B, revealing in
an orderly manner the market's changing
appraisal of the value of each company's
equity.
The final figure (Figure 4) shows the action of
P/E and E/B as indexes relative to the comparable
DJIA ratios. The P/B index is not shown, but its
trends and variations can be approximated by
visualizing a line half way between the P/E and the
P/B indexes.
Figure 4 shows clearly that stocks which "beat
the Dow" in profitability level also beat the Dow in
price/earnings ratios.
1. The counter movement continued to appear even after the influence of the market
was removed. GM is a marvelous "mirror
image"!
2. The price/earnings index of the more profitable stocks generally had an upward
trend, while the P/E trend of the less fortunate stocks was unfavorable. This probably
reflected the increasing emphasis on
"growth" stocks in the latter years of the
period studied.

Financiai Analysts Joumal / January-February 1995

3. High volatility and low payout tended to

reduce the level of the price/earnings index.
4. Comparison of Figures 3 and 4 shows that
the market influences strongly both price/
earnings ratio and price to book ratios.
CONCLUSION
This study of the 30 DJIA stocks hardly provides
the reader with the sort of news which impels him
to run, shouting, into the board room. Most of the
results were known or expectable through the
reader's experience or intuition.
Yet, throughout the study, profitability shines
forth as a clear beam of light, leading the way to
the price paid for equity assets. Retum on equity
appears as a direct influence on the price/earrungs
ratio, re-emerges as a major cause of growth and is
seen in a consistent pattern with earnings stability.
Even payout is controlled by expectations of profitability.
The counter movement and the "U" characteristics guide us in understanding why there is no
neat linearity between P/E and E/B. We have also
seen that growth and earnings instability cause
exponential rather than linear relationships. Hopefully, we can now grasp the dangers of a simplistic
approach to earnings capitalizers and price to book
ratios. The approach to price must consider the
interplay between the multiplier and profitability
in the light of the counter movement, the "U"
characteristic and other non-linear ingredients.
There are obvious advantages to a system
which could appraise all stocks in terms of a
multiple of equity assetsthat is, a ratio of underlying market worth to book valueas opposed to
the currently popular system of valuing stocks in
terms of earnings per share in some cases and
equity assets in others. Since the basic earning
power of a company can be expressed in terms of
return on equity, there is no reason why analysts
cannot, if they wish, reorient their approach toward a unified system based on price to book
n^ultipliers rather than earnings multipliers. An
asset approach need in no way inhibit the concept
of discounting future values, and has the special
advantage of forcing the analyst to study the asset
needs of growtha sadly neglected art. An asset
valuation approach would also provide, automatically, for the counter movement and the "U"
characteristic. We submit that the P/B formula is a
basis for such a system.
Finally, we have reviewed the DJIA in some
detail. To the degree that (1) the structure of our

71

1955-1964
Rgure 4.

Indexes of P/E Ratios and E/B, 1949-1962

DJTA - 1 0 0
300

GM

DD

GE

200

100

50
200

G F

TX

PG.. . '

100
60
200

UA "

SD

GT

100

50
200

IP

ACD

JM

100
50
200 _

BS

AC

100

50

20
200

WX

HR

SWX

100 -.

50

25

E/B
P/E

economy, (2) the political and social environment,

and (3) the course of international affairs have
changed, we can expect the stock market to change
from what it has been in the past. Though the
future will not re-enact the past, the stock market

will remain wedded to the fundamental elements

of stock values. The emphasis on each element will
surely change, but the elements will remain tied
together in the same structural relationship which
we have discussed.

Financial Analysts Joumal / January-February 1995

1955-1964
FOOTNOTES
1. F.E. Block, "The Place of Book Value in Common Stock
Evaluation," financial Analysts Journal (March/April 1964):
29-33.
2. N. Moiodovsky, "A Theory of Price-Earnings RaHos," The
Analysts journal (November 1953):65-80.

Financial Analysts Journal / January-February 1995

3. See S.F. Nicholson, "Price-Earnings Ratios," Financial Analysts Journal (July/August 1960):43-45.
4. M. Kisor, Jr., "The Financial Aspects of Growth," Financial
Analysts Journal (March/April 1964):46-51.

73