Making the right investment is not as simple as it seems. It is often said to trust your instinct while making an investment, but without proper research, even the best of investments may turn out to be an underperformer. Even though the asset may be different, the process of investment remains the same. After zeroing in on an asset for investment, one will have to evaluate the asset. Evaluation is a crucial step, irrespective of the asset class. The process of evaluation is complex in the case of physical assets like real estate, however, in the case of equities, financial ratios and charts can give significant information. While investing in equities, investors often get confused between the return on equity (ROE) and valuation.
What is important?
To understand the importance of ROE and valuation, it is crucial to get an idea of both the metrics individually. In simple terms, ROE is the net income of a company for every penny of shareholder’s equity. It is calculated by dividing the net income by shareholder’s equity. The shareholder’s equity is considered for ROE as it is equivalent to the assets of the company after deducting the debt. ROE essentially is the measure of how effectively the management of the company utilises its assets to generate income.
Valuation is not a single metric like the ROE. It is the process of valuing the worth of the asset. The question arises, how can one value the worth of a listed company? Some of the popular tools to determine the market value of a company are earnings per share (EPS) and price to earnings ratio (P/E ratio). The EPS and P/E ratio provide a fair idea of the current market value of a listed company.
ROE vs valuation
If you have to invest in a company, what metric should you rely on, ROE or valuation? Many investors just look at the ROE and invest in a company. However, relying solely on the ROE to make an investment may not be the right approach. ROE reveals only one aspect of the investment. The ROE will give you an idea of the return you can expect on the investment in the future, but it doesn’t take into account the current valuation. If the current valuation is too high, the effectiveness of the management may not be able to make a significant difference in the returns generated. For example, let us assume that you spend Rs 50,000 to acquire 1% in a company. The company has generated a net profit of Rs 3 lakh in a year. With a 1% shareholding in the company, you will be entitled to Rs 3000 from the net profit. Suppose the company has a high ROE of 120%. Even if the company maintains the same rate of ROE, you will need over 16 years to get your investment back.
ROE and valuation
The ROE is not the most effective measure to use on a standalone basis. Instead of ROE vs valuation, one should focus on ROE with valuation for successful investing. The tools most commonly used for valuation are EPS and P/E ratio. One can get the EPS by dividing the total income of the company by the total number of outstanding shares. It is a better metric than the absolute income number as it makes comparison easier. The P/E ratio is calculated by dividing the current market price by the EPS. It is a metric to know how much investors are willing to pay for the stock. It is said lower P/E is good, but it is not universally correct. The P/E ratio should always be compared with peers to get a better idea. Similarly, ROE is also an industry-specific tool. The ROE of industry peers should be taken into consideration before finalising an investment.
When you consider ROE and valuations together, there can be three scenarios—low P/E ratio and high ROE, high P/E ratio and high ROE and high P/E ratio and low ROE. The first scenario is the most ideal one for an investor. Low P/E ratio doesn’t mean, low P/E in absolute terms, but relatively low P/E. A company is worth investing even if both the P/E and ROE are high, but it is best to avoid a company with high P/E and low ROE.