We have learnt about the price to earnings ratio in our Financial Analysis class and based on it we have often gotten into debates regarding the undervaluation or overvaluation of the subject companies with our colleagues. We are guided by our professors, textbooks etc. that one cannot look at the price to earnings ratio in isolation and reach to any particular conclusion from it.
To address this limitation the model we are going to discuss here is going to use two inputs P/BV and ROE.
Price to earnings ratio = Current market price / Earnings per share
EPS actually is return to the equity shareholders on the book value invested in the business.
Return to equity shareholders = Book value (total net worth) * Return on Equity (ROE)
Using the above two equations the formula for price to earnings ratio can re-written as –
Price to earnings ratio = (Current Market price/ Book value per share)/Return on equity
P/E ratio has been dissected into these two components because analysis of these two factors historically has shown that the P/BV multiple very closely tracks the changes in the returns on equity. (Analysis shown below)
I took the Price to book value ratio and return on equity (%) of 50 companies forming the NIFTY index and plotted these values on a scatter plot and then generated the best fit line from the coordinates. With a little eye balling we can conclude that most of the coordinates lie close to the best fit line displaying that market is pricing most of the NIFTY 50 companies in line with their Return on Equity (%). Also we can see a strong R-square of 0.736.
From the above, intuitively we can conclude that the coordinates lying above the best fit line show the stocks which are valued above what markets actually generally expect and vice versa for points lying below the best fit line. And higher the distance of coordinates from the best fit line higher will be the extent of over/under valuation.
Despite low ROE, market may value a particular stock at higher multiples as compared to the market in general because of reasons like high expected future growth and contrary to this higher ROE need not necessarily lead to a higher price to book value ratio because of risks associated with the business/company.
The above analysis can be done for different indices, sectors etc. depending on the requirement.