ROE: P/E’s Brother From Another Mother
As a value investor, I want to maximize ROE while minimizing P/E
Return on Equity (ROE) is a measure of a company’s annual return (net income) divided by the value of its total shareholders’ equity, expressed as a percentage (e.g., 20%). ROE can also be derived by dividing the firm’s dividend growth rate by its earnings retention rate. Warren Buffet has reportedly said that ROE is his favorite metric.
Mathematically, ROE is simple:
or
ROE is a true bottom-line profitability metric, because its comparing the profit-available-to-shareholder to the capital provided or owned by stakeholders. Whereas, ROA and ROIC each depict a variant of profitability available to both debt and equity investors, ROE stays pure, just comparing to the capital owned by just equity investors. Simply, your ROE is 20% if you have a capital $1000 for running a business, then you will able to squeeze net income of $200 from that capital without influenced by any debt. In conceptual sense, it’s the profitability measure that equity investors care most about.
Let’s get a closer look at ROE…
If you’ve heard of the price-to-earning (P/E) ratio, you’ve seen ROE’s half-brother. P/E as we know, divides stock price at the end of the period by net income per share outstanding or EPS.
It is financial ratio to value company whether company’s stock price is overvalued or undervalued. For example, In table 1, If you buy a company A stock with price $4500 with the earning-per-share (EPS) of $300, then the P/E is 15. On the other hand, company B which is similar industry as company A has $5000 stock price with EPS $200, then the P/E is 25. It could be concluded that company A has less P/E ratio than company B which mean if you buy company A price stock of $4500 you will get earn-per-share (EPS) of $300 which more higher than company B’s EPS that is $200 with price stock of $5000. It means that stock price of company B is overvalued.
We can see in the formula, it include EPS, where EPS increase with rise in growth of the company. As EPS increase, P/E comes down thus making that company a favourable asset for any investor.
If we flip P/E, we get E/P, or earning yield. As example above, your earning yield from the purchase of company A stock is 7%, then if purchase of company B stock you will get earning yield 4%.
Earning yield (E/P) is reciprocal of the P/E ratio, expressed as a percentage:
Now, just replace the market value of equity (synonym of Market Capitalization) with the book value and you’ve got ROE.
Which as we know that,
Book value = Total equity – Noncontrolling interest
Then,
A market value of equity denominator shows how much a company earns per the value the market assigns it (a valuation concept), whereas a book value denominator shows earnings relative to the internal equity it had to work with (arguably closer to an operational profitability concept). By using Du Point analysis we can explain how close relationship between ROE and P/E. Du Point analysis is a method of measuring the performance of a company. As per Du point analysis, ROE(Return on Equity) is affected by three major ratios, which profit margin, total asset turnover and financial leverage.
ROE = Profit Margin x Asset Turnover Ratio x Equity Multiplier
ROE= (Net income/sales)*(Sales/Total asset)*(total asset/total equity)
Sustainable Growth Rate (SGR) can be calculated by:
SGR = ROE x (1 – Dividen Pay Out ratio)
If all the factors are held constant, if leverage increase (i.e. increase in debt), increase the Equity Multiplier (EM). So, as the ROE increases, then SGR also increases. So, it means as the growth increases, ROE increases, thus increasing EPS, which puts pressure on P/E, making the company cheap and favourable equity to add on to the portfolio.
Summary
Screening for companies which have consistently high ROE and low P/E (and low P/B) can throw up some interesting bargains particularly in times of market stress
Source
- https://www.investopedia.com/articles/investing/120513/comparing-pe-eps-and-earnings-yield.asp
- https://corporatefinanceinstitute.com/resources/knowledge/finance/what-is-return-on-equity-roe/
- https://www.investopedia.com/university/ratios/profitability-indicator/ratio4.asp
- https://www.investopedia.com/terms/m/market-value-of-equity.asp
- https://www.quora.com/Is-there-a-relationship-between-a-companys-P-E-ratio-and-its-growth-rate
- https://seekingalpha.com/article/2557745-the-relationship-between-roe-p-b-and-p-e-as-seen-in-at-and-t?page=2
About Post Author
Screening for companies which have consistently high ROE and low P/E (and low P/B) can throw up some interesting bargains particularly in times of market stress : will definitely do as a beginner like me. Thanks for the insight mas.
Your welcome.. thanks
Relatively high or low ROE ratios will vary significantly from one industry group or sector to another,, nice share fi..
It’s interesting article. Now I know that the higher number of PE ratio, it doesn’t always mean good for the company. Thank you for sharing
interesting article, now I know how to assess whether the company’s stock price is overvalued or undervalue by comparing EPS and P/E each company.
Thanks mas alfi.