Rating stocks on Return on Equity
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.