Return on equity (ROE) is a popular measure when valuing a company. It gives the investor an idea as to how profitable a company will potentially be in the future. It can also be used to try and get a handle on future profits.
But first, a quick reminder on how to calculate this ratio.
The equity side of the ratio is derived from the balance sheet and is calculated as total assets less the total liabilities. In other words, equity is also the net asset value (NAV). This figure can be determined for the whole business as a nominal value, or it can be divided by the number of shares in issue. In the last-mentioned instance we talk about NAV per share.
What equity tells us is the breakup value if a business were to be liquidated, everything sold off and all the debts repaid. A stock will trade at a premium to this number as we’re not buying a stock for its breakup value, but rather for its future profits.
Let’s say Company A has a ROE of 20% on a NAV of R100. We’d then expect the profit to be R20. That is 20% of R100. Company B may have a lower ROE of 15%, but on a NAV of R200, resulting in a profit of R30. Surely the R30 profit looks better, but the ROE tells us that company A is better at extracting profits from the business as they have the higher ROE.
There are some challenges with this method. The most obvious one being that ROE changes from year to year. Now, a decent business will have a fairly stable ROE, making it easier, but it’s still not perfect.
Many boards will target a certain ROE, but while targets are great, they are not fixed, and we have some listed stocks that seem never to achieve their stated ROE target. Other listed stocks have very low ROEs in the low teens or even single digits. This means they’re not very profitable compared with a company with a ROE of 20%.
ROE can also be skewed by booming profitable years. As such I like to use a seven-year average ROE when using this ratio.
The NAV is generally far more static and increases slowly over time, but it can be weakened by spikes in debt or boosted by write downs.
So, here’s an example of using ROE to try and determine the profitability of a company – and hence a potential future price.
Let’s take Astral Foods. Its ROE since listing in 2001 is just over 29% with a current NAV of R96 per share. If Astral can produce the 29% ROE, you would get R27.84 of profit per share. Now, the long-term average price-to-earnings ratio (P/E) for the share is around 11 times and we can use that to determine a share price by multiplying the profit per share by the average P/E. That gives us a share price of just over R306.
Astral’s current share price is under R170 on a P/E of just over six times. So, the stock is largely tracking its ROE, but is being discounted by the market on a much lower than average P/E.
This begs the question: Is there an opportunity for investors? Perhaps a better question is why the market is marking Astral down at a P/E almost half its average?
Is it because of drought concerns? Or is it due to the dumping of chicken from overseas? Both these factors hurt profits but in this example the discount to the longer-term average seems excessive and would indicate there is some potential for an Astral investment using just a simple long-term ROE, NAV and long-term historic P/E. This is not perfect, but it is a great place to start.