Q&A: P/B Ratio, ROE, Using Equity Capital in Valuation

Modified on June 30, 2020

The current article in this series provides responses related to:

  • 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.
  • Sector specific (Top-down) approach for stock selection
  • Importance of equity capital as a parameter for stock selection
  • Getting the investing books recommended for beginner investors
  • Technical vs fundamental analysis approach of stock investing

 

ROE & P/B ratio as interlinked valuation parameters

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.

 

Using market value created for every ₹1 of retained earnings

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!

 

Valuation Parameters

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.

 

Sector based investing

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.

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,

 

Use of Net Profit/Equity Capital in Valuations

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,

 

How to get Investing Books recommended for Beginner Investors

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.

Read: Investment Books For Beginners

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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