One often hears that P/B indicates growth: A high P/B is a growth stock. This is not true:
- A firm can have a high P/B but zero growth (Cell D in the tic-tac-toe game)
- A firm can have a high P/B but negative growth (Cell G in the tic-tac-toe game)
- A firm can have a low P/B but positive growth (Cell C in the tic-tac-toe game)
An example of the first two cases is a pharmaceutical firm with high P/B because its R&D asset is missing from the balance sheet. It reports positive residual earnings (RE) it is not expected to grow or even decline. The decline could be due to the R&D no longer delivering residual earnings as high as currently…lower profitability from the R&D pipeline. This can be seen from the valuation formula for enterprise value:
Price can be considerably higher than NOA0 on the balance sheet with positive (RNOA1 – r).NOA0 but g can be zero or negative.