How To Pick Stocks Using Return On Equity

How To Pick Stocks Using Return On Equity

A great stock investment is one that is selling at a low P/E ratio and that has a high forecast growth in earnings per share. If the earnings per share grow fast then the stock price has to grow along with the earnings (if the P/E remains constant). If earnings per share continue to grow rapidly, then the only danger the investor faces is that the P/E will shrink. That can easily happen if the stock is purchased at a high P/E. But, if the P/E is low when the stock is purchased then as earnings per share grow, it is not likely that the P/E will fall.

If we are not expecting the P/E to increase, then the only way a stock’s price can grow is if the earning per share grow. Therefore it is clear that a great stock to invest in should be one that is expected to have a rapid growth in earnings per share.

Clearly then, it is important to be able to predict which companies will show high growth in earnings per share.

All else being equal, companies with a high return on equity will show the highest growth in earnings per share. In fact, in the absence of a dividend and in the absence of share issues or share buy-backs, a companies earnings per share will grow at exactly the same rate as the return on equity. The sustainable growth rate is return on equity times the percentage of earnings that is retained (as opposed to paid out as a dividend). This establishes the mathematical fact that a company with a higher sustained Return on Equity can be expected to grow earnings at a higher rate than a company with a lower return on equity, assuming both companies pay out the same percentage of earnings as a dividend. Furthermore, if the P/E ratios remain constant then it is a mathematical fact that the company with the higher sustained return on equity will provide a higher growth in stock price, again assuming both companies pay out the same percentage of earnings as a dividend.

A high return on equity is therefore a very good thing, however, we must be cautious not to pay too high of a P/E ratio. Mathematically, a high P/E stock automatically has a higher price to book value ratio then a low P/E stock, given the same return on equity.

The following table illustrates the relationship between the Return on Equity, the Return on Market Value, the Price to Book-Value ratio and the P/E ratio.

(1) (2) (3) (4)
Forecast Return on Equity Price to Book-Value Ratio Price / Earnings Ratio First Year Earnings Return On Market Value
    =(2)/(1) =(1)/(2)
10% 0.5 5 20.00%
10% 1 10 10.00%
10% 2 20 5.00%
10% 4 40 2.50%
25% 0.5 2 50.00%
25% 1 4 25.00%
25% 2 8 12.50%
25% 4 16 6.30%

Observations:

The first company earns 10% on equity and all else being equal, the second company earning 25% on equity is a stronger and better company. However, which company is the better investment also depends on the price of the stock.
If the first company earning 10% Return on Equity can be purchased at a price to book value of just 0.5, then this implies a very attractive P/E of 5 and implies that the investor can expect to earn (in the first year) 20% on the money invested in the stock provided that the company does earn 10% ROE and the P/E does not change. This example also assumes a no dividend applies. However if the first company earning 10% Return on Equity can only be purchased at a price to book value of 4 which is equivalent to a P/E ratio of 40, then this implies that the investor can expect to earn (in the first year) only 10%/4 = 2.5% on the money invested, assuming the P/E remains unchanged and again assuming no dividend applies.

This illustrates the fact that the price to book value or the P/E ratio must be used in conjunction with the Return on Equity. It is not enough to know that the Return on Equity is 10%. It should also be apparent that buying at a P/E ratio of 5 which is equivalent in this case to a price to book value ratio of 0.5 is much less risky than buying at the higher P/E ratio of 40 (price to book value of 4). It is less risky because a P/E of 5 is a lot less likely to decline then is a P/E of 40. This assumes that we are equally confident that the Return on Equity will continue at 10% in both cases.

If we look at the Second company with a return on Equity of 25%, the same math applies. The difference is that the return on the investors money is a lot higher for each P/E or price to book value. With a Return on Equity of 25% even a P/E of 40 equates to an expected return on the investors money of 6.3%. It should be apparent that a higher Return on Equity justifies paying a higher P/E or a higher multiple of book value.

If the P/E or price to book values are equal then the company with the higher expected Return on Equity is clearly the more attractive investment.

Note that paying twice book value for the 25% Return on Equity Company is more attractive than paying just book value for the 10% Return on Equity Company. The investor expects to earn more by paying the higher price for the higher quality company. This is directly indicated by the P/E ratio which is 8 for the 25% company and 10 for the 10% company.

However, consider the choice between paying book value for the 10% ROE company and earning 10% on your investment or paying four times book value for the 25% ROE company. In this case the investor expects to earn 10% annually on the 10% company. However on the 25% Return on Equity company the investor expects to earn only 25/4 = 6.25% on the investment the first year. However due to retained earnings, the investor expects to earn 6.25% on the original investment but 25% on retained earnings. By the second year, the investor is earning just over 10% and in the long run, due to retained earnings the investor’s return would approach 25% per year. This illustrates that it can make sense to pay a relatively high multiple of P/E or price to book value in order to access high retained earnings rates going forward.

The above analysis assumes that the initial Return on Equity is sustainable. The challenge for investors is to identify companies that have high sustainable Return on Equities but not to be too optimistic in projections.

The above analysis indicates how to use price to book value and the P/E ratio in conjunction with the Return on Equity to identify good stock picks.

Company managements that really understand investment math will focus on and discuss achieving a high return on equity because they know that it mathematically drives earnings per share growth which benefits investors. Company managements that do not focus on achieving a high return on equity, and sadly this is most managements, do not “get it” and should be avoided.

Shawn C. Allen

Editor, Investorsfriend.com

September 13, 2003