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Can ROE Substitute for Share Price? Figures 2.1 and 2.2 suggest that the gulf between academicians and practitioners over the proper measure of financial performance may be narrower than supposed. The graphs plot the ~arket value of equity_ divided by book value of equity against ROE for two representative groups of companies. The ROE figure used is a weighted-average
• ■ 52 Part One Asressi11g the Fi11a11cial HMlth of the Firm ROE over the most recent three years. The solid line in each figur~ is a regre~~ion line indicating the general relation between the two variables. The no_t1ceable pos1t1ve r~la-tionship visible in both graphs suggests that high-ROE compa_nies t~nd to have high stock prices relative to book value, and vice versa. Hence, working_ to increase ROE ap-pears to be generally consistent with working to increase _stoc_k pn~e. . . The proximity of the company dots to the fitted regression Imes 1s also interesting. It shows the importance of factors other than ROE in determining a company's market-to-book ratio. As we should expect these other factors play a significant role in determin-ing the market value of a company's shares. For interest, I have indicated the positions of several companies on the graphs. Note in Figure 2.1 that Ametek is virtually on the regression line, indicating that based purely on historical ROEs, Ametek's stock is fairly priced compared to those of other electrical and electronics companies .. In Figure 2.2, Pfizer, a leading drug company, and Anheuser-Busch take the prize with RO Es of almost 40 percent although Gillette wins market-to-book honors at almost 16 times. DuPont on the other hand, appears to be the Rodney Dangerfield of the stock market. Despite a ROE of more than 30 percent, it ·can't get no respect" among in-vestors who assign it a mediocre market-to-book ratio. Evidently, investors are skeptical that the company can continue such performance. Note too the difference in scale be-tween the two figures. Donaldson Company in Figure 2.1 appears to be a high-flyer with a ma~ket-to-book ratio of about 5 times; yet on Figure 2.2, a ratio of 5 would be nothing special. _Investors a?pear not terribly enamored about the prospects for electrical and electronics companies. To summarize, these graphs offer tantalizing evidence that despite its weaknesses, ROE may serve as at least a crude proxy for share price in measuring financial performance. FIGURE2.1 Market Value to Book Value of Equity Ratio versus Return on Equity for 41 Electrical and Electronics Companies 6 "' .: 8" 4 'o ~ 1 3 i .. jAcroscicnce • •N~: .. Donaldson Dcw~y 0 I I I I I I I I I O S W U W ~ M ll • Weighted average rc1um on equi1y (%) The regression equation is MVIBV = l.lJ + 8.5 ROE, where MV/BV is the market value or equity relative to the book value or equity and ROE is a weighted average or return on equity in ZOO! and the prior two years.