On Capital Market Ratios and Stock Valuation: A Geometric Approach

Abstract

This paper presents a new technique for the empirical analysis of some capital market ratios and stock valuation. We first show how capital market ratios (such as the price to earning ratio) can be plotted in a constructed stock valuation box. Within the box we can also plot the contours of several associated valuation measures. Analysis of the properties of the traditional capital market ratio (the price earnings ratio, PER) suggest that they should be supplemented by a new index, the PERS (value ratio) index. We show how changes in the value of PERS are associated with changes in the ratio of the current earnings of the firm to the sum of value of the firm and current earnings, and how this may alter our economic interpretation of changes in the patterns and direction of stock values. We do also some empirical analyses to show that the new measure of PERS is better the the traditional one.