Hi Team,
Could you please explain me the statement number 2 with simple example?
Not able to get it logically.
Thanks.
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You may think of it mathematically.
Justified PB ratio = IV0/B0.
In the residual income model, IV0 = B0 + PV of Residual Income
If PV of Residual Income is negative, then it’s essentially, B0 + (-PV of residual Income). That’s lower than BV.
So, the Justified PB ratio is less than one.
Logically, a PB ratio < 1, signifies that the firm didn’t create value at all, infact at times, destroyed value. This is in line with PV of RI being negaive, given RI = B0 (ROE – Re). Essentially it means, the company was not able to generate Return on Equity above it’s Cost of Equity, therefore, destroyed value.