Asthereturnonequityincreases,theequitymultiplesallgo
up.Atverylowreturnsonequity,thefirmwillhavetoissue
substantialnewequitytosustainitshighearningsgrowth,and
theequityvaluepershare decreasestoreflectthepotential
dilution. Ifreturns onequity dip belowthecost of equity,
growth canstartdestroying equityvalue. In this particular
illustration,whenthereturnonequitydropsbelowthecostof
equityof 10 percent,increasingthegrowthratewillreduce
equityvalues. Inour discussionof companionvariables in
Chapter7,wearguedthatthemultiplethatismost closely
connectedwithreturnonequityistheprice-to-book equity
ratio.Ifwedefinethedifferencebetweenthereturnonequity
and thecost ofequityas themeasureof excessreturns to
equityinvestors, there isclearlya linkbetweentheexcess
returnsearnedandwhetherafirmtradesat,below,orabove
book equity. Figure 8.7 presents the effects of changing
excess equity returns on the price-to-book equity ratio.
FIGURE 8.7Excess Equity Return and Price-to-Book Ratio