Evaluating companies using ROE and PER

Came accross an article from The Star today: Ways to evaluate a company. Below are some of the excerpts (in green) with my comments (in blue):

Some investors may be wondering, between return on equity (ROE) and price earnings ratio (PER), which method is more suitable to value a company. According to John Neff, ROE is regarded as the best single measure of managerial performance because it shows the management’s ability to generate profit from the capital it employs. It is the ratio of net income to shareholders’ equity.

Warren Buffett said a good business should be able to achieve good ROE without employing high debts. Companies with high gearing are vulnerable to financial risk during the economic downturn and high interest rate environment. Besides, any future investment plans should be funded by internally generated cash flow without having to call on shareholders to contribute. Unless the return generated from the shareholders’ money is greater than ROE, it will show lower shareholders’ returns as a result of the enlarged share capital.

(A brief explanation to those without a financial background: Business can be run with 2 types of funding, Debts and Equity. Debts include loans from banks, leasing and etc and they carry fixed interest charges, regardless if the company is making money. So, in a bad time, when the company is not making much money and with margins squeezed, those with heavy debts are usually those to go down first. The US subprime crisis is an example of how deadly debts can be. Equity are also known as Capital or Shareholders' Fund, include Reserves, Retained Earnings and Paid Up Capital.)

As Buffett is a conservative investor, he prefer companies who are able to generate profits without using much debts and hence, will have higher resilience during bad times. In other words, he think a good company should be able to return good profits to shareholders with minimum capital. However, an aggressive business usually doesn't mind to take on extra debts to fund its expansion, provided the extra returns generated from such expansion is sufficient to cover the interest expense. That's why we have another ratio called "Times Interest covered" which measured how many times the earnings can cover the interest costs. Anyway, ROE is one of my favorite tool in finding "the right company to invest".

PER is defined as the market price of a company divided by its earnings per share (EPS). The principle behind this method is the concept of payback period. This ratio tells us how many times the price is greater than the annual earnings of a share. For example, Company A is currently selling at a PER of 15 times. This means that it takes 15 years for an investor to get back his returns through the company’s annual earnings, assuming that the company will produce the same EPS during that period.

A higher PER implies that it takes more years to get back your returns from the company’s earnings. Based on the academic view, a higher PER is better than a lower one because this implies that investors are willing to pay more than the normal market PER. Nevertheless, in practice, most analysts will say that a lower PER is better because it implies that the company is undervalued and cheap at the current valuation. So which view should we follow?

In an efficient market, companies that are selling at a higher PER are better than companies with a lower PER. This is because when the market is efficient, the current price will reflect past, current and future information.

That is also why high growth companies in highly efficient market like those Google, Yahoo, Alibaba and etc command high PER. People are buying into the idea that they will grow exponentially and bringing down the PER in a few years' time.

In Malaysia however, most academic researchers have concluded that our stock market is not efficient, which implies that the current stock prices do not reflect all information. Hence, there may be some potential past or future information that is not fully reflected in a stock’s current price. Given this, it is quite possible to find some undervalued companies on Bursa Malaysia if we select those with low PERs.
First, we have to understand what causes a company stock to be sold at a low PER, where the market price is lower relative to its earnings. However, not all stocks with low PER imply good value for investing. As mentioned earlier, sometimes the cheap valuation may be a true reflection of certain negative aspects of the company, for example, poor corporate governance, high gearing, uncertainty of future earnings and or it is facing litigation. However, as a result of asymmetric information, not all investors are fully aware of the market’s worries. Hence, analysts with the necessary knowledge, skills and market information play a very critical role in helping investors to analyse companies in detail and identifying those that are truly undervalued based on fundamentals.

One additional point: when we look at past PER, we do not look into any single year or only the latest PER. There might be a year or two when the company is able to earn extra income from some "one-time" gain like selling of properties or revaluation of assets and etc., which might not necessarily reoccurring in the future. Hence, PER is only useful when evaluating a stable company who has been making consistent income over the years.

Also, do not fully trust most PERs published in the newspapers or magazines because they might be using different calculation method. Some of them are even outdated. It is still better to compute your own PER based on the latest company's announced financial reports.

On a side note, low ROE companies (<10%) usually have low PER(<10).