14.18 Interpreting Market-to-Book Ratios.

The variables that affect the market-to-book ratio are (1) the excess of ROCE over
the cost of equity capital; (2) the growth in common shareholders’ equity, which
is positively related to ROCE and negatively related to the dividend payout per-
centage; and (3) the number of years during which a firm is expected to earn an
excess return over its cost of equity capital. Summary data in the table below help
in interpreting the market-to-book ratios for these seven firms. The growth in
common shareholders’ equity equals one minus the dividend payout percentage
times ROCE.

Bristol-Myers Squibb—Bristol-Myers Squibb has the highest market-to-book

ratio because it has the largest excess of ROCE over the cost of equity of the sev-
en firms. Its price-earnings ratio for the year is close to average for the seven
companies, suggesting that its earnings are likely persistent and do not likely in-
clude significant transitory income items. The large number of years of excess
earnings at the ROCE of the current year required to generate a market-to-book
ratio of 13.9 is due to the large dividend payout percentage (77%). If the dividend
payout ratio for Bristol-Myers Squibb were 44%, in line with those of the other
companies, the required years of excess earnings would be only 15.5 years.

Warner-Lambert—Compared to Bristol-Myers Squibb, Warner-Lambert has a

similarly high market-to-book ratio of 13.0 but a lower ROCE (35.0%) and a
slower historical rate of growth in earnings (5.1%). The relatively high price-
earnings ratio for the current year suggests that Warner-Lambert’s earnings for
the current year include some negative transitory items; so its recent ROCE is un-
derstated. Thus, its long-term ROCE can be expected to exceed the 35% for the
current year. The excess of ROCE over the cost of equity capital also would be
higher and would justify a higher market-to-book ratio.
Eli Lilly—The market-to-book ratio of Eli Lilly is quite high at 12.4 even though
the ROCE is the lowest of the seven firms. However, the price-earnings ratio of
Eli Lilly is extremely high, suggesting that earnings for the current year include
some negative transitory items. Thus, the ROCE for the current year likely
understates the long-term ROCE and the excess of ROCE over the cost of equity
capital. The relatively high cost of equity capital for Eli Lilly also reduces the
excess return. The market apparently filtered out the effect of these transitory
items and granted the firm a relatively high market-to-book ratio. The large
number of years of excess earnings needed to generate a market-to-book ratio of
12.4 also relates to the understated ROCE and high cost of equity capital.

Pfizer—Pfizer’s market-to-book ratio of 11.2 falls in the middle of the seven

companies. Its relatively high excess of ROCE over its cost of equity capital, cou-
pled with the highest growth rate in earnings in recent years, suggests that its
market-to-book ratio should perhaps be even higher. The fact that Pfizer’s price-
earnings ratio is not excessively high for this industry suggests that Pfizer is gen-
erating a normal level of earnings and that the market anticipates that it will sus-
tain this level of earnings and earnings growth in the future.

Abbott Laboratories—Abbott Laboratories has the second-largest excess of

ROCE over the cost of equity capital, the fastest growth rate in shareholders’
equity, and the smallest number of years of excess earnings required to generate a
market-to-book ratio of 10.4. Its price-earnings ratio, however, is on the low side
relative to the other companies, suggesting that the earnings for the current year
include some positive transitory items. Thus, future ROCE is likely to fall, and
lower future ROCE will reduce its excess return and the corresponding market-to-
book ratio. Abbott Laboratories has the highest growth rate in shareholders’
equity as a result of large ROCE and the lowest dividend payout percentage.

Merck—Merck’s market-to-book ratio of 10.3 is a function of a somewhat lower

excess ROCE, which results in part from a high cost of equity capital. Its price-
earnings ratio falls near the middle of the seven firms, so earnings do not likely
include significant transitory items. The large number of years of excess earnings
required to generate a market-to-book ratio of 10.3 results from the relatively
small excess ROCE.

Wyeth—The market-to-book ratio of Wyeth is 6.9, the lowest of the seven firms.
Its price-earnings ratio is lowest of the seven firms, and its historical growth rate
in earnings is also on the low side. This suggests that Wyeth’s recent earnings re-
flect positive transitory items and that future earnings and ROCE will be lower,
which leads to a lower market-to-book ratio. The low market-to-book ratio results
in part from the somewhat higher dividend payout percentage and the slower
growth in shareholders’ equity.

You might ask the class why the market-to-book ratios in the pharmaceutical in-
dustry exceed 1.0 to such a significant extent. Pharmaceutical companies must
 expense R&D costs in the year incurred, which reduces net income for the ex-
penditures made each year but reduces shareholders’ equity for cumulative R&D
expenditures. Because of the significant lag between making R&D expenditures and
generating revenues and positive earnings from those expenditures, the mar- ket values
the expected benefits several years before the accounting records rec- ognize those
benefits. Thus, market values of equity will exceed book values.

Summary of Data for Seven Pharmaceutical Companies (Problem

14.18)

Market- Growth in Excess

to-Book Shareholders’ Earnings
Company Ratio ROCE – RE Equity Years
Bristol-Myers Squibb ..... 13.9 0.355 0.112 58.3
Warner-Lambert ............. 13.0 0.217 0.182 32.0
Eli Lilly........................... 12.4 0.126 0.163 89.8
Pfizer .............................. 11.2 0.207 0.200 27.8
Abbott Laboratories........ 10.4 0.315 0.261 13.5
Merck.............................. 10.3 0.177 0.179 41.9
Wyeth ............................. 6.9 0.202 0.167 24.6