Combining Earnings and Book Value in Equity Valuation

It is common to apply multipliers to both earnings and book value to calculate approximate equity values. However, applying a price†earnings multiplier or a price†to†book multiplier typically produces two valuations and the analyst is left with the question of how to combine them into one valuation. This paper calculates weights that combine the valuations and shows that these weights vary over the difference between earnings and book value, doing so systematically over time. When earnings are small compared to book value, the weights are different from when earnings are large relative to book value, and they vary in a nonlinear way over the difference between the two. The weights also combine forecasts of future earnings, based on earnings and book value separately, into one composite forecast. The paper calculates a second set of weights to ascertain how the two numbers are combined to forecast one†year†ahead earnings and three†years†ahead earnings. The calculated weights are applied out of sample to ascertain their predictive ability against other benchmarks.