When the excess returns are negative, thestock trades at
below book equity. In fact, when the return on equity is
expectedtobeequaltothecostofequityinperpetuity,the
stock trades at book value. Ignoring return on equity
differences when comparing price-to-book equity ratios
acrosscompanieswouldbefollyandleadustoconcludethat
lowreturnonequitystocksarecheap(sincetheytradeatlow
multiples of book equity).
Another,albeitlessdirect,measureofearningsqualityisthe
netprofitmarginthatacompanygenerates.Again,usingthe
linkagebetweennetmarginsandreturnsonequitystatedin
theearliersection,wecanstatetheexpectedgrowthrateasa
function of the net margin: