In equity valuation theory (Justified P/B Model), why does a commercial bank generating a consistently high Return on Equity (ROE = 20%) command a significantly HIGHER Price-to-Book (P/B) multiple than a bank generating an ROE of 8%?

[ A ]Because banks with 8% ROE are exempt from all banking taxes.

[ B ]Because under the Gordon-based P/B model [ P/B = (ROE - g) / (Ke - g) ], a firm earning an ROE higher than its Cost of Equity (Ke) creates positive economic value on its equity capital base, justifying a premium multiple above book value.[ CORRECT ]

[ C ]Because P/B ratios are determined strictly by the Reserve Bank of India.

[ D ]Because book value has zero connection with return on equity.

Takeaway

Option B is correct: Because under the Gordon-based P/B model [ P/B = (ROE - g) / (Ke - g) ], a firm earning an ROE higher than its Cost of Equity (Ke) creates positive economic value on its equity capital base, justifying a premium multiple above book value.

Derivation

The Justified P/B framework links a bank's valuation multiple to how efficiently it deploys shareholder capital relative to what shareholders require in return. Under P/B = (ROE − g) / (Ke − g), when ROE sits meaningfully above Cost of Equity, each incremental rupee of book value the bank retains generates returns exceeding what investors demand, which is genuine value creation priced at a premium to book. A bank earning 20% ROE against a 14% Ke compounds wealth faster than the market's required rate, while one earning only 8% ROE against the same Ke arguably destroys value on each retained rupee, dragging its P/B toward or below 1.0x.

Why the others fail

A — Because banks with 8% ROE are exempt from all banking taxes.

Corporate taxation under the Income Tax Act applies uniformly regardless of a bank's ROE; tax exemption has no bearing on why P/B multiples differ by ROE.

C — Because P/B ratios are determined strictly by the Reserve Bank of India.

Market P/B multiples are set through price discovery by investors in the secondary market, not fixed or dictated directly by the Reserve Bank of India.

D — Because book value has zero connection with return on equity.

P/B is directly linked to ROE relative to Cost of Equity under the Gordon-based model; the two are not unconnected, contrary to what this option claims.