Making the right investment is not as easy as it seems. It takes a lot of research to get the right stocks for your portfolio and without proper understanding or usage of the analytical tools, the investments can turn out to be underperformers.
After deciding on a stock that you are interested in buying, it is important to evaluate it. It is a crucial step but a complex process. For stocks, there are a number of ratios, charts and other technical tools that can help an investor understand the fundamentals of the stock and help him/her decide. Return on Equity (RoE) and valuation are two such tools.
RoE is a financial ratio that helps in measuring a firm's ability to generate profits from its shareholders’ investments. It is the return generated on the equity of a firm. It also helps compare firms to its peers from similar sectors as well as evaluate a firm's financial performance.
Meanwhile, valuation means how much the company is worth in the market. Different investors use different methods to gauge the valuation of a firm. It is also influenced by the potential investors see in the firm's future.
A number of technical tools are used to determine this valuation. While very simple it could be taken as the market capitalisation of a firm, which is the total number of shares multiplied with the price of each share at a particular time. However, different investors use different tools to identify the market value of a firm. Some use the price to earnings ratio (P/E) or price to book (P/B) ratio to determine the valuation while some use earnings per share (EPS) to find the same and some use all three. They all give a good idea of the current market valuation of a listed company. It also helps to evaluate if stock is fairly-priced, overpriced, or underpriced.
How are they calculated?
Return on Equity (ROE) = Net income / Total shareholder's Equity of the Company.
Return on equity is calculated by dividing the net income of a firm by its shareholder's equity. Shareholders equity is basically total assets minus total liabilities. It is how much shareholders will get if the firm was sold today.
Now, let's look at how the valuation ratios are calculated.
EPS measures the profitability of a firm on a per-share basis but does not account for the convertible options. It is calculated by this formula: EPS = (Net income – Preferred dividend) / Outstanding shares. You take the net income of a firm and subtract the preferred dividends and then divide the result by the total outstanding shares of the firm.
P/E Ratio is the ratio between a company's stock price and its earnings per share. It is used to determine the market value of a firm. P/E Ratio = (Current Market Price of a Share / Earnings per Share). A high P/E indicates a stock price is high compared to its earnings and vice versa.
Meanwhile, the P/B ratio compares the market value of a stock to its book value. It helps determine if the stock is undervalued or overvalued.
P/B Ratio = Current share price/ book value per share.
Book Value per Share = (Total Assets – Total Liabilities) / Number of outstanding shares
P/B ratio generally indicates whether the stock is worth how much the investor is paying and how much will the investor get if it goes bankrupt. Usually, if the P/B ratio of a stock is lower, then it indicates that the stock is undervalued and vice versa.
RoE and valuation
RoE should not be used as a singular tool to decide the right stock for you. Also, it is important that while comparing RoEs of 2 stocks, they should be peers and in the same industry.
An investor should together use RoE as well as the valuation ratio to better understand a stock, not separately.
Like for example when you take RoE and P/E ratio together. While comparing 2 stocks, the one with a low P/E ratio and high RoE is the most ideal scenario for an investor. A low PE means that the stock is not expensive while a high RoE indicates that it has good potential.
If a company has a high P/E and high RE, it can still make for a good choice, since even though the stock is a bit expensive, it has good potential. However, it's not wise to choose a stock with a high P/E and low RoE.
Meanwhile, generally, RoE moves in tandem with the P/B ratio. A stock with a high P/B ratio will usually have a high RoE and will be a good choice for investors. However, any sizable difference between the two can be a warning signal. Like stocks with a high P/B ratio and low RoE may indicate that the shareholder’s equity is not increasing or that it is overvalued, making the stock, not the best choice. Or conversely, a high RoE but low P/B ratio may show that the stock is really undervalued.
So while choosing a stock, it is pertinent that you take both RoE and valuation ratios into account. Together they can help you choose a stock with great growth potential.