What is the link between the ROE and the P/E ratio?

Guide To Fundamental Research | Published on 31st July 2018 | 3207

Have you ever wondered why is it that companies with high ROE tend to have higher P/E Ratios? Take the case of sectors like FMCG and to a lesser extent IT and pharma. While IT and pharma have seen their ROE under pressure in the last few quarters, they still enjoy the highest levels of ROE in the Indian markets. Intuitively, it does look quite appealing. A company that generates more for shareholders will get a better P/E since the P/E is what the shareholders are willing to pay for every rupee earned. Investors will obviously be willing to pay more for companies that enjoy higher margins, higher growth or higher ROE. Let us first focus on the concept of ROE a little deeper.

Return on Equity (ROE) is the return generated on the equity of the company. Equity, here, refers to the share capital of the company plus its retained earnings. Any monies in the share premium account are also added to equity. Let us look at equities from the other side. Equity of a company can also be looked at as the net assets of the company (Total Assets of the company – all external liabilities). ROE is what is generated on this equity and that is why it is so important because equity represents the owned funds of the company.

The need to break up the ROE…

To understand the importance of ROE and its relevance for the P/E ratio of a company, we need to break up the ROE into four components. ROE is a function of four factors viz. leverage, cost of leverage, operating profitability and efficiency of the company. Therefore, the ROE can be mathematically expressed as under:

Return on Equity (ROE) = Profit after Tax / Total Equity of the Company.

This can be further broken up as under:

ROE = (PAT / EBIT) X (EBIT / Sales) X (Sales / Assets) X (Assets / Equity)

Here, the PAT/EBIT represents the cost of financial leverage of the company. The EBIT/Sales measures the operating profitability of the company. The Sales / Assets ratio measures the asset turnover or the efficiency of asset utilization. Finally, the Assets/Equity ratio measures the overall leverage of the company. ROE can be positively impacted by enhancing any of the above four ratios. Let us see why each of these components has a bearing on the P/E too…

Why PAT / EBIT has a bearing on the P/E Ratio of the company…

PAT / EBIT ratio measures the cost of financial leverage or how the interest cost of the firm is managed. Lower the interest burden and tax burden the higher is this ratio. You must beware of some smart manipulation that is possible here. This ratio can be propped up by smart tax management by deferring tax outflows, tweaking interest flows, creating bullet payments etc. Go beyond the corporate veil and delve into finer details like the actual cost, the currency risk etc. But, market love companies that can grow with low debt costs.

It all boils down to how much your core operations are generating

The EBIT / Sales ratio is the Holy Grail for analysts. It measures the operating margins of the company earned from its core operations. For example if the company is in the business of steel; then the ratio captures the profit generated from the core steel business only. It exclude the impact of interest and tax as well as extraordinary items. Markets are always giving to give a higher P/E discounting for growth from core operations.

You need efficiency beyond profitability

Sales / Assets ratio captures how effectively assets are utilized and churned to generate sales. A higher sales/assets ratio is a good sign as it shows that your assets are not lying idle and are being put to productive use. This is undoubtedly accretive to your P/E ratio.

The trade-off of leverage or debt on books

Leverage is always a trade-off. You can add debt to your books but you must not let solvency issues creep in. That is the trade-off. If you can enhance your earnings by adding debt but without causing insolvency risk to rise, then you have a good case for upward P/E rerating.

Finally, 2 points on the ROE – P/E ratio linkage…

  • ROE and the P/E relationship are actually pointless at a single point of time. The trend has to be seen over a period of time. If ROE is showing an upward trend, the market will be willing to reward the company with P/E ratios. Look at autos and FMCG. But if ROE is falling, then market will punish the stock with lower P/E Ratios. IT and pharma are cases in point.
  • There is an interesting trade-off between dividends paid out and ROE. When a company does not have too many investment opportunities, they pay out more by way of dividends. That is when markets lose interest and the P/E ratio comes down. But companies that plough back a large part of their earnings for future investment need to ensure that they enjoy high levels of ROE. A combination of high ROE and high retention is a classic recipe for higher P/E ratios.