There are asset-based methods of valuation and there are earnings-based methods of valuation. Then, there is the PB-ROE valuation which incorporates both earnings and asset factors into a single ‘metric’.
Understanding How PB-ROE Works
The Price to Book (PB) ratio is used to value companies as a function of their net asset ownership which is often regarded as a proxy of liquidation value. Consequently, a common characteristic of low PB companies is that they are either loss-making or have very poor profitability and this can be a very unappealing for certain investors.
This is where Return on Equity (ROE) comes in. ROE measures the level of profitability based on the amount of net assets owned by a company. By incorporating ROE, PB-ROE measures how cheap the assets of the company are in relation to their level of profitability.
Warren Buffett: If You Own A Good Business, Keep It
Consider 2 companies which are both trading at 0.5x PB. However, Company A has an ROE of 10% while Company B has an ROE of 5%. Based on PB-ROE, Company A is obviously the cheaper one. But you probably don’t need the PB-ROE framework to tell you that. Its usefulness comes in when you have companies with different PBs and ROEs.
What if Company A has a 0.6x PB while Company B is trading at 0.4x PB? Assume that their ROE is as above. The PB-ROE framework tells us that you are paying 0.06x PB (0.6/10) per 1% ROE for Company A but 0.08x (0.4/5) PB per 1% ROE. So Company B is actually 33% more expensive than Company A, even though it has a lower PB.
Using PB-ROE in Singapore Market
How do you tell what is considered cheap? The easiest way would be to compare it with companies of the same industry. To give a rough idea of how this can be done and the benchmark for Singapore stocks in general, we have plotted every Singapore-listed company based on their PB and ROE.
Each point represents a single company and the figures are based on the most recent financial year.
The black line represents the mathematically calculated relationship between PB and ROE for Singapore stocks in general.
The red region, where majority of the data point lies, visually confirms the positive relationship between PB and ROE, so we are not talking crap. The red line represents a more conservative PB-ROE benchmark for cheapness based on the red region. This is just our rough estimation and is by no means accurate.
Plot the data point for a company which you are researching on. The company is considered cheap if it is below the black or red line (depending on how conservative you want to be). For the more mathematically-inclined, you can use the equation for greater degree of accuracy.