P/E, P/B Evaluating Indicators and their Combined Performance Using Residual Income Model in Tehran Stock Exchange

Because of the restrictive assumptions contained in the traditional equity valuation models, this paper uses Fairfield Residual Income Model for equity valuation. This model is an adjusted state of the dividend discount model (DDM) that doesn’t assumes a fixed relation between accounting data and future dividend, and restriction on payout policy. Book value and earnings play major roles in this model. It starts with book value (net assets) and for reflection of the expected profitability of those assets, adjusts it upward or downward. The price/earnings ratio (P/E) is a function of expected changes in future profitability, and the price/book ratio (P/B) is a function of the expected level of future profitability. Based on model prediction and earned results from this investigation, P/B correlates positively with future return on book value, and P/E correlates positively with growth in earnings. Findings show that different P/E – P/B combinations are associated with distinct patterns of future profitability.