Get clues from ROE and PBV

Get clues from ROE and PBV

In the last two articles, we have discussed about the Price to Book Value (PBV) and Return on Equity (ROE) separately.

Now, let’s look at the relationship between the ROE and the PBV, and how you can get some investment clues from these two useful financial ratios.

There is a direct relationship between the ROE and the PBV, where this relationship gives you insight into whether a stock is undervalued, overvalued, or fairly valued.

According to the valuation expert Aswath Damodaran of the Stern School of Business at NYU, he illustrates the relationship of the two ratios as below:

  1.   A high ROE with a high PBV , or a low ROE with a low PBV means the stock is reflecting its fair value;
  2.  A high ROE with a low PBV means the stock is undervalued; and
  3. A low ROE with a high PBV means the stock is overvalued.

The relationship can be illustrated as below:

Relationship

Low PBV

High PBV

 

High ROE

Undervalued

High ROE

Low PBV

Fair Value

High ROE

High PBV

 

Low ROE

Fair Value

Low ROE

Low PBV

Overvalued

Low ROE

High PBV

Clearly, a company with a high ROE, as compared to another company with a low ROE, should have a higher PBV.

However, when there is a divergent relationship between the ROE and the PBV, it is either a buying opportunity, or time to sell the stock.

Let’s look at the example below to identify which company is worth investing in:

Company

A

B

C

D

Average

ROE

14%

8%

12%

10%

11%

PBV

1.5x

2.4x

2.1x

1.8x

1.95x

From the table, you may discover that:

  • Company A has a high ROE (as compared to the average ROE) but low PBV (as compared to the average PBV);
  • Company B has a low ROE but high PBV;
  • Company C has a high ROE and high PBV; and
  • Company D has a low ROE and low PBV.

By applying the valuation matrix as highlighted above, and based on the observation of the four companies, you may conclude that:

  • Company A is undervalued,
  • Company B is overvalued, and
  • Company C and Company D are reflecting fair value.

In short, Company A is presenting a buying opportunity, while holders of Company B shares may consider disposing.

Also, the valuation matrix of the relationship between the ROE and the PBV, is best used to compare the companies in the same industry.