Q&A: P/B Ratio, ROE & Others

Modified on July 2, 2018

The current article in this series provides responses related to:

  • Investing in PSU (Public Sector Undertakings) Banks
  • Illustration of ROE & P/B ratio as interlinked valuation parameters
  • Relevance of “₹1 increase in market capitalization from ₹1 of retained earnings” test over bull and bear phases.
  • Deciding about the buy price of any stock
  • Difference in the company data on screener/moneycontrol and the annual report of a company; and which data source an investor should use
  • Sector specific (Top-down) approach for stock selection
  • Importance of equity capital as a parameter for stock selection
  • Clarification about “Reserves” and “Retained Earnings” in the balance sheet
  • How to decide about selling a stock
  • Technical vs fundamental analysis approach of stock investing

 

Query

Dear Sir, your site is good and informative. I have invested in SBI and would like to know if I should continue for long term.

Author’s Response:

Thanks for writing to me!

I do not prefer investing in PSU banks due to a number of reasons.

PSU banks do not have long term CEO/Chairmen tenors. Every person on top comes with a fix tenure of 3-4 years and in order to keep his/her record clean, he/she tries to show the result in the joining quarter (resultantly joining financial years r) as bad as possible. All the provisioning is usually done within one quarter in order to wipe the slate clean. This by no means should be interpreted that provisioning should not be done or is to be avoided. However, the way PSU banks show cyclical trend of bad to good results and then again bad with a frequency of 3-4 years. It indicates that something else other than shareholders’ interest is also at play. Most of the times, the management seems to be motivated by short term vision. SBI shows the same trend with years of chairman changes 2011, 2014 etc. showing exceptionally bad results.

Due to certain reasons, PSU banks always seem to have higher non-performing assets (NPAs) than their private counterparts. Higher NPAs hurt shareholders’ interests. SBI also has higher NPAs than most of private banks.

Currently, I am not invested in any PSU bank. In future, I may or may not. However, you should decide about holding or selling SBI, for your own reasons. I have presented you with mine.

Hope it helps!

Query

Hi Vijay,

Great viewpoint and also completely different from the general perception.

Why Return on Equity (ROE) is not meaningful for Stock Market Investors!

However, I would tend to diverge from this view, because let’s suppose there are two companies A and B earning same profit after tax (PAT) ₹100/year and their book values are ₹1,000 and ₹2,000 respectively (hence ROE is 10 and 5 respectively). Now, if we buy company A at 2 times book value and company B at 1 time book value, ideally, we bought them at same valuation as per your view.

But shouldn’t company A get more premium compared to B since it can generate same profits on less assets compared to B. Also it shows that capex requirement of A is less and hence, it should command higher premium. So I believe company A in this case is cheap compared to B.

Kindly provide your views on this.

Author’s Response:

It’s interesting to get your queries and answering to them. I appreciate the effort you put in while going through the articles and providing your inputs for the benefit of the author and readers of www.drvijaymalik.com

Company A is definitely good at P/B of 1. It might still be good at P/B of 2. But there would be a P/B level at which it would not remain attractive. This level can be P/B of 3 or 5 or 10. The main point here is that ROE alone does not give the true picture. Purchase price will always be a factor to determine its usefulness for any investor.

You would appreciate that in markets different people interpret same set of data with different conclusions. This difference in perception creates market and generates trade.

Query

We are very thankful to you for providing such an invaluable information regarding company analysis for investment. Sir, in majority of the companies analysis you have mentioned “$1 in market value for $1 of earnings retained”.

My doubt is that when there is a bear market, majority of the good companies (companies selected as per your shortlist criteria) fail to meet this criterion. Similarly, in a bull market even the worst companies will meet this criteria. Kindly tell your viewpoint.

Author’s Response: 

Thanks for your feedback. I am happy that you found the articles useful.

You are right that in bear market, most of the companies might fail this test whereas in bull market most of the companies would pass this test. However, that would happen only if you take the $1 test only for short duration.

If you use this test for long periods of time, which covers bull as well bear phases, then this test makes a lot of sense and true wealth creators get differentiated from wealth destroyers.

Read: How to do Financial Analysis of a Company

I use $1 test for past 10 years because most of the times a period of 10 years coves entire business cycle (sometimes multiple business cycles).

Hope it clarifies your query!

Query

I was wondering if you could either provide advice or direct me in the right direction. I’m currently running a successful share portfolio based on principles of Warren Buffett and Trident Confidential.

I’m interested to know the best way to value a stock price based of earnings and how to asses a maximum buy price for a stock.

Regards

Author’s Response:

Thanks for writing to me!

There are many parameters that I use to access whether the current price of a stock is at attractive levels. These parameters vary from:

  • Price to earnings ratio (P/E ratio),
  • P/E to growth ratio (PEG ratio)
  • Earning yield (EY) and its comparison to G-Sec/Treasury yield (margin of safety)
  • Price to Book value (P/B ratio)
  • Price to sales ratio (P/S ratio)
  • Dividend Yield (DY)

I have written a detailed article valuation analysis of stocks where I have covered the reference values of each of these parameters that I use to make investment decisions. You may read the article here:

How to do Valuation Analysis of a Company

Hope it helps.

Query

While analyzing company data, I get confused which website to use Screener, monyworks4me or balance sheet of company from its portal (tedious job of data entry). Many a times, company portal data is different from screener. Can you please clarify the reasons for the difference?

Author’s Response:

Thanks for writing to me!

Data in the balance sheet of the company is the most authentic data about any company. You should use it to make final investment decision about any company. However, as you also acknowledge, it entails tedious job of data entry. Therefore, annual report financial data should analyzed once you are satisfied from analysis of the company from the information available on the public sources like screener, moneycontrol etc. that the company financials represent a potential good story.

Open portals like Screener etc. use the data from company report and rearrange it to keep consistency between the data formats reported by them. This may involve regrouping of certain items which may give the impression that the data on screener is different from annual report.

Therefore, it is recommended that an investor should open portals like screener to filter stocks based on her favorite parameters, do preliminary analysis based on their data and if satisfied, then see the annual report to make final decision. By following this process, an investor can make good use of the limited time she has got.

Hope it helps to resolve your query.

Query

Hello Sir,

I would to know future of power sector because Prime Minister Mr. Narendra Modi has announced 24*7 electricity for India in next 5 years.

Can our investment remain safe in private power sector companies like Adani Power Limited, Tata Power Company Limited etc.? My investment horizon is for a long time up to 4-5 years r.

Author’s Response:

Thanks for writing to me!

As mentioned by me in the article on conducting business analysis of a company, I am a bottom up investor and do not have views on industries.

Read: How to do Business Analysis of a Company

I believe that there can be good investment opportunities in non-growth sectors as well. Therefore, I do not have any view on power sector.

Regards,

Query

I thank you very much for sparing your valuable time to reply to me.

Sir, in some of the company balance sheets, retained earnings are not mentioned. Can I consider the “Reserves” mentioned as retained earnings??

Are company reserves and retained earnings same or different??

Author’s Response: 

Thanks for writing to me!

Reserves and retained earnings are not the same thing. Retained earnings are a part of reserves, but reserves contain many other things as well. Reserves may contain retained earnings, premium on shares issued, any increase due to revaluation of companies assets etc.

Retained earnings (RE) are the profits which are not distributed to shareholder by dividends. You can calculate RE for any year by deducting (dividend + dividend distribution tax) from net profit. RE is effectively the part of profit which a company invests in its own business.

Read: Understanding the Annual Report of a Company

Regards,

 

Query

Hi Vijay,

Basically I am looking for stocks with a small equity capital like CRISIL Limited, Symphony Limited, Colgate Palmolive (India) Limited, Procter & Gamble Hygiene & Healthcare Limited etc.

However, as we cannot expect a small equity capital for a company like Tata Consultancy Services Limited (TCS), therefore, we have to relate it with net profits. E.g. net profit of TCS is ₹19,163cr and its equity capital is just ₹195. Hence Net Profit/Equity cap gives you a ratio of 98, which is awesome.

You can ignore market cap/PE*equity capital as market cap/PE = net profit only.

If you find a company with these characteristics, even with moderate growth of 12 to 15 percent, your return on equity will be more.

Author’s Response: 

Thanks for your inputs!

As per my understanding, equity capital on a standalone basis is not a significant parameter for stock analysis. It is the shareholder’s equity (Equity Capital + Reserves & Surplus), which contains the equity capital that was contributed by shareholders while establishing the company and reserves & surplus i.e. shareholders’ money (profits) retained by company. Initially contributed or subsequently retained money, both are equally significant.

Therefore, I believe that the comfort, which small equity capital might give an investor, is only notional.

Regards,

Query

Dear Dr Vijay

I am reading the article on how to analyse companies. I am a big fan of your blog. I want to know:

  • How to decide the target price of stock when you buy and
  • Secondly, your exit strategy when you buy a stock.

Author’s Response:  

Thanks for writing to me! I am happy that you liked the articles.

Target price (upper cutoff purchase price) is based on the valuation level at which an investor is comfortable to buy any stock. I follow a checklist approach and prefer buying into companies at P/E ratio of <10. So P/E of 10 acts as a tentative upper cutoff price for me. You may read about other criteria of my checklist here:

Final Checklist for Buying Stocks

An investor should hold the shares till the time the stock is showing good business performance. A company should be sold only when its business gets deteriorated in an irreversible manner. Market price should not be the factor to decide about selling a stock.

You may read the following article for the guidelines that I follow while selling any stock:

When to Sell a Stock

Hope it helps.

Query

Hi Dr Vijay

While reading the article “Top Stocks to Buy”, I saw that you have analyzed the data for last 10 years.

  • According to you how many years’ data should be analyzed?
  • Secondly, can you please tell your views on banking sector and ICICI Bank stock?

Author’s Response:

Thanks for writing to me!

I believe that the data for as many years as available should be analyzed. Here you see that I am using 10 years data for two reasons:

1) If one analyses 10 years data then one can observe the company’s performance during different phases of economic cycles. 10 years r period usually contains at least one complete cycle of economic upturn and downturn, hence it gives a picture of company’s performance in different times.

2) It is easily available at screener.in

Views on ICICI Bank:

I work for an Indian private sector bank. I do not want to comment/opine about these stocks as knowingly or unknowingly, I might base my opinion on information which may not be in public domain. Therefore, I request you to let me skip this query.

Query

1st of all thanks for posting such a good stock analysis framework. I want to know the source from where we can get all books recommended by you?

Sir, if you don’t mind can you explain me what is the basic difference between fundamental analysis & technical analysis & how can I relate this analysis with charts?

One more thing, I want to send you some stock charts of a single stock: 5 day, 1 month, 3 month, 6 month & 1yr. Can you explain the same to me as I want to learn chart reading?

Please give your email address so I can send you the charts.

Author’s Response: 

Thanks for your feedback!

The hyperlinks to the books would take you to page of these on Amazon site. These are affiliate links. You may buy the books by clicking on these links.

You may learn the difference between technical analysis and fundamental analysis by reading this article:

Choosing the Stock Picking Approach suitable to you

I no longer follow technical analysis, therefore, would not be able to help you with chart reading. You may find my reasons for leaving technical analysis and selecting fundamental analysis as the preferred method of stock selection, in the following article:

Why I Left Technical Analysis And Never Returned To It!

Regards,

P.S.

 

DISCLAIMER

  • The above discussion is only for educational purpose to help the readers improve their stock analysis skills. It is not a buy/sell/hold recommendation for the discussed stocks.
  • I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013.
  • Currently, I do not own stocks of the companies mentioned above in my portfolio.

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