Investment strategy based on empirical relationship between price to book and price to earning ratio

Abstract

Stock Valuation is the process by which the underlying of a stock is established on the basis of its forecasted risk and return performance. The question of whether and to what extent a stock is under or overvalued is resolved by comparing its current market price to its intrinsic value. Most commonly used models of valuation are discounted dividend model and relative valuation methods. However, in this study accounting based valuation framework has been used. The Residual Income (Ri) model estimates the intrinsic value of stock by using both the current period book value of equity on the balance sheet and forecasted earnings. The total equity of the firm is a function of the book value of equity and the sum of the present value of residual income. Nearly all the CNX S&P NIFTY stocks have been valued on the basis of pro forma analysis of Residual Earnings. The stocks were then classifies on the basis of intrinsic value in the appropriate cells of Relationship Matrix between P/B & P/E Ratios. This classification was compared to that obtained on the basis of analysis of current residual earnings and future expected residual earnings. Nearly 30 out of 48 stocks in CNX S&P NIFTY were found to be mispriced. Only 20 stocks appear to be identically classified in both the tables. Grossly mispriced stocks were identified and their under/ over valuation have been explained on the basis of Price-earning to growth (PEG) ratio. On the basis of ratio between intrinsic values to current market prices investment strategies have been suggested. The analysis presented here was based on the sample portfolio consisting of CNX S&P NIFTY Index. Same can be applied by investment analysts and portfolio managers to any portfolio of their choice. The analysis has been presented in this report for demonstration purposes and therefore rigor has been compromised in favor of simplicity. Beside to maintain objectivity in the analysis the forecast have been made primarily based on observed historical date and trends. A more detailed application of the Residual Earnings Model along-with incorporation of expert views and analysis opinions about future trends can present picture significantly different from that presented here.