Rat­ing stocks on Re­turn on Eq­uity

Finweek English Edition - - INVEST DIY - BY SI­MON BROWN

Valu­ing cycli­cal shares (such as min­ing and con­struc­tion) is al­ways very tricky due to t he v ol at i l i t y of t hei r earn­ings. One day they’re boom­ing, as we saw back in the lead up to the 2008/09 f inan­cial cri­sis, and the next thing they’re all bust as we see to­day.

Of­ten one would use a rolling price/ earn­ings ra­tio (PE), tak­ing five or even seven years of earn­ings and us­ing that av­er­age for de­ter­min­ing the PE and other valu­ing met­rics. This smooths the volatil­ity but still gives trou­bles, es­pe­cially when ei­ther the boom or the bust is es­pe­cially pro­nounced.

Then I heard a great con­cept at a JSE Power Hour event I at­tended in Cape Town re­cently. Shaun van den Berg from PSG Wealth was pre­sent­ing on “think like a busi­nessper­son when in­vest­ing”. On a side note, I love the con­cept of treat­ing in­vest­ments like busi­nesses we’re in­vest­ing in rather than just the buy­ing of stocks. We are buy­ing com­pa­nies and we need to al­ways re­mem­ber this fact.

But back to the main point, Shaun was talk­ing about us­ing an av­er­age re­turn on eq­uity ( ROE) in­stead of earn­ings growth, es­pe­cially when do­ing a price/earn­ings to growth (PEG) cal­cu­la­tion.

We wrote about t he PEG ra­tio in this col­umn t wo weeks ago, but a quick re­fresher: PEG is PE di­vided by ex­pected earn­ings growth. Be­low 1 is con­sid­ered cheap, while a PEG above 1 is con­sid­ered ex­pen­sive. Shaun’s process was fairly ad­vanced and I have tweaked it a bit, mak­ing it sim­pler.

Let’s step back and un­der­stand what we’re do­ing first. Price and earn­ings we know and un­der­stand.

ROE starts with the E part – eq­uity. Eq­uity is from the bal­ance sheet and is all the as­sets less all the li­a­bil­i­ties, so re­ally the net as­set value (NAV) of the com­pany. Re­turn on this eq­uity looks at what prof­its the com­pany is mak­ing from their eq­uity. So we take net in­come (t yp­i­cally af­ter div­i­dends have been paid) and di­vide this into eq­uity for a WHEN IN­VEST­ING, MET­RICS ARE THE EASY PART. THE IS­SUE FOR A COM­PANY STUCK IN THE DOL­DRUMS IS WHAT NEEDS TO HAP­PEN TO SEE IT MOV­ING HIGHER AND, IM­POR­TANTLY, WHEN WILL

THIS HAP­PEN? per­cent­age value.

Ty pica l l y, we’ l l s ee a num­ber some­where in the mid-teens, although, with lo­cal re­tails we’re see­ing some amaz­ing num­bers at around 50%, while some of the large banks are north of 20%. The at­trac­tion of us­ing ROE is that it in­di­cates what the sus­tain­able growth rate is within a com­pany over the pe­riod (es­pe­cially when us­ing a smoothed ROE). Us­ing a smoothed ROE in a PEG will help re­duce the volatil­ity in earn­ings that we see in these cycli­cal stocks.

With this re­vised PEG, use price as nor­mal. For earn­ings I would sug­gest us­ing an av­er­aged five years of HEPS. I again pre­fer the av­er­age f ive-year earn­ings as it re­duces the volatil­ity. This tweak will change the PE value but gives a bet­ter in­di­ca­tor of the cur­rent val­u­a­tion of the com­pany over the long term.

For ex­am­ple, us­ing WBHO we have a f ive-year av­er­age ROE of 18% and a five-year av­er­age HEPS of 1 130c and a cur­rent price of 9 500c. Us­ing this fiveyear HEPS we get a PE of 8.4 (oddly ex­actly what the cur­rent PE ac­tu­ally is but this won’t al­ways be the case). For the growth we use the 18% ROE and crunch­ing it all to­gether we get a PEG ra­tio of un­der 0.5. The short ver­sion: it tells you WBHO is very cheap and I agree, but at al­most any met­ric the stock is.

But the next ques­tion is when will it rerate higher – and that is the harder ques­tion. When in­vest­ing, met­rics are the easy part. The is­sue for a com­pany stuck in the dol­drums is what needs to hap­pen to see it mov­ing higher and, im­por­tantly, when will that hap­pen? In the case of con­struc­tion I don’t know, so I stay away even though the stocks are cheap.

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