A Basic & Useful Ratio Comparison

equityROE or the return on equity of a company can be a very useful financial ratio when used in combination with others. Return on Equity is Earnings/Equity or what the company can earn on invested capital. For example lets say you purchased a house for 100,000 and sold it one year later (Ex all fees and taxes for illustration purposes) for 130,000 you would have 30,000 profit.

30,000/100,000 = 30% ROE

Now when used in comparison with PE or price to earnings ratio you can find discrepancies between the market price and equity valuations. Earnings/Price gives you the PE but the price is the market capitalization “Mr. Market” is willing to give you on any given day or during any given period. Now lets take any given company, for this example I will use Apple (AAPL). Assume the price given by the market is 425B but the company earns 42.5B net income annually or otherwise known as priced at 10P/E. (42.5/425 x 100)

Now lets assume Apple has a ROE of 30% that means for every 1$ of “EQUITY” invested it can generate a 0.30 cent return annually but the market is using irrational behaviour quoting it at 0.10 earnings for each $1 of “PRICE” invested. Equity being a balance sheet item and rough approximation of business liquidation value, price being what someone is willing to pay on any given day, a stark difference.

Understanding the difference between market capitalization and equity (Assets-Liabilities=Equity) is very important and should not be used interchangeably as one has much more volatility from day to day and week to week but should be used in comparison to see what the company could generate relative to the market quote.

My past experiences have led me to believe management as well as the prudent investor should actively buy shares (or buyback) when ROE exceeds P/E, although this is one ratio and should be used in conjunction with many other ratios (P/S, FCF, OCF, PCF, P/E, P/B, ROE, ROA) as well as thorough analysis of company annual reports and SEC filings. Most importantly ROE must be viewed from a historical average over 7-10 years minimum, assuring ROE is not declining consistently over the period.

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4 thoughts on “A Basic & Useful Ratio Comparison

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