The P/E Ratio is price/earnings the inverse of this ratio is earnings/price percentage. If we substitute the price for equity we get Return on Equity. However the of the price/earnings ratio and return on equity usually differ, why?
Difference Between Inverse P/E Ratio and Return on Equity
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12-08-2012, 05:24 PMlouDifference Between Inverse P/E Ratio and Return on Equity
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12-08-2012, 05:39 PMwinner69lou - the 'price' and 'equity' are not the same thingQuote:
Originally Posted by lou
'price' is market capitalisation (market value of the equity per se) while 'equity' is what is shown in the accounts (balance sheet)
Rarely does a company have it's equity valued by the market the same as in the accounts (a price book ratio of 1). If it was the ratios you mentioned would be the same -
12-08-2012, 05:55 PMwinner69
lou - do some sums around RBD
price P is 216 cents while equity E is about 33 cents
earnings the same for your p/e and e/p and roe calculations
hope you get different answers -
12-08-2012, 09:56 PMlouQuote:
Originally Posted by winner69
RBD P/E Ratio is 12.3 therefore;
12.3=216/E
12.3E=216
E=18cents (EPS)
Inverse P/E would be:
18/216=8.3%
Return on equity calculation would be:
EPS/Equity
18/33=55%
To me it seems that the ROE is useless when comparing which company to invest in because there is such a disconnect between the market value of equity and the book value of equity.
I am missing something here. What else can use the ROE percentage for? Do people use it when investing in the sharemarket (evaluation of shares)? -
13-08-2012, 06:54 AMLizard
ROE is useful in considering the ability of a company to grow earnings. However, still needs to be considered in terms of how scalable the business is. In a very scalable business, it is possible to use ROE to determine how quickly a business can grow without needing additional capital - that then provides a useful input to a valuation.
Also, have a look at "DuPont Analysis", as this is a useful way to look at the factors behind ROE. -
13-08-2012, 08:14 AMwinner69
lou - RBD fantastic ROE eh. Company really doing well in churning out such profits on what money (capital) was actually invested in and retained in the company.
The reward is the market now values that equity at a much higher value - Market Value Added (MVA) some call it. In RBDs case 183 cents worth
MVA is in simple terms the NPV of the returns over the cost of capital (which inlcudes debt). So work out from today what these returns might be and that is one way of putting a valuation on RBD. -
13-08-2012, 06:15 PMlouDuPont Analysis:Quote:
Originally Posted by Lizard
ROE = (Profit margin)*(Asset turnover)*(Equity multiplier)
= (Net profit/Sales)*(Sales/Assets)*(Assets/Equity)
= (Net Profit/Equity)
The Du Pont identity breaks down Return on Equity (that is, the returns that investors receive from the firm) into three distinct elements. This analysis enables the analyst to understand the source of superior (or inferior) return by comparison with companies in similar industries (or between industries). -
13-08-2012, 09:11 PMlouThis is all good however it is retrospective.Quote:
Originally Posted by winner69
However this does not give an indication of if it is undervalued, overvalued or fairly priced.Quote:
The reward is the market now values that equity at a much higher value - Market Value Added (MVA) some call it. In RBDs case 183 cents worth
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13-08-2012, 09:17 PMlou
Return on equity is great if you have invested the equity (ie a private business). However when you start to purchase equity (purchase shares) you need to measure your return against the price paid.
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13-08-2012, 10:16 PMSauceBoom.Quote:
Originally Posted by lou
Nicely said Lou. And with that gem of a sentence I believe you just elegantly answered your own question!
That is, implicitly, the relationship you were looking for in your original question and what makes Return On Equity useful.
Say a business pays out 100% of its profits as dividends and makes a 30% return on equity. Now assume you are able to buy that equity at its original value (called book value). You would be getting an amazing 30% return on your money!
But what if the same business was listed on the open market and people are able to bid against each other for that equity. Is it reasonable to assume investors might pay more than the book value if the return is that high? Say the investors bidding would be happy with a 10% return rather than a 30% return, how much would they have to bid the equity up to get a 10% return?
Obviously they would have to bid the equity to 3 times its original value to turn the 30% return into a 10% return for them.
So there is an intrinsic link between the Return On Equity and the price someone will pay for it.
Just like you stated above you have to measure the return against the price you pay.
If the ROE was 40% you could pay 4x the equity to achieve a 10 % return. 20% would be 2x the equity. And so on.
Mathematically the relationship can be expressed:
ROE / 'RETURN YOU WANT' * EQUITY = VALUE
or
30% / 10% = 3 * EQUITY = VALUE
Basically, you can work out how much you would be prepared to pay for the equity, by looking at the return it generates, and comparing that to the return you want.
You can also see what assumptions about future returns are built into a share price already by looking at the return on equity and the multiple of equity it trades at. (Is it trading above, below, or equal, to the book value of its equity? and what does that say about what the market thinks its future returns will be?).
The maths gets a little bit trickier when the funds are compounded internally (i.e. reinvested not paid out as a dividend).
Ideally you want to buy a business that can reinvest the excess cash it generates and compound it at high rates of return on the incremental equity (retained earnings). You also want to buy the current equity of such a business as cheaply as possible; not an easy opportunity to find by any stretch of the imagination. You will notice that businesses with a track record of reinvesting funds at the very high rates of return also trade at the biggest premiums to the book value of their equity.
Obviously you have to make incredibly difficult assumptions about the sustainability (or not) of the returns that may be generated in the future for your valuation to be correct. And that, of course, is the really hard part.
You shouldn't just extrapolate past results out into the future without an understanding of why those returns are likely. That means understanding the underlying business and its competitive position. Which is incredible hard to do and be correct. This difficulty and uncertainty is why many investors (notably very famous, successful ones) insist on a "margin of safety" as a buffer in case they are wrong.
Another way of thinking about Return on Equity is that it is a measure of the 'underlying economics of the business.' The Market Value of the equity is simply what people will pay for the underlying economics.
The reason that comparing the price paid for equity to the return on equity is better than comparing the price to earnings, is because it gets closer to the core economics and how efficiently the assets are being used. This is particularly useful when assessing the benefit of future growth opportunities. PE ratios do not tell you anything about how much money had to be injected in the past to create the current stream of cashflows which is a huge disadvantage.
Cheers
Sauce