The P/B-ROE Valuation Model Revisited

Abstract

A two-stage stock valuation model derived from the P/B-ROE approach is shown to be a surprisingly effective tool for a broad variety of uses, including the explanation of current prices and the prediction of future return differences. This applies both to the cross-section of individual U.S. stocks and the time series of the S&P 500 index. Besides offering a new closed-form expression for firm value, the model measures the investment horizon over which the market predicts exceptional profitability, demonstrates the dependence of expectations for future profitability on past volatility of return on equity, and quantifies the extent of the recent U.S. stock price bubble. Perhaps the model's most persuasive result is its no-look-ahead statistical support for tactical asset allocation.