Can
ROE
Substitute
for
Share
Price?
Figures
2.1
and
2.2
suggest
that
the
gulf
between
academ
ici
ans
and practitioners
over
the proper measure
of
financial performance may
be
nar
r
ower
than supposed.
The
graphs plot the
~arket
value
of
equity_ divided by book value
of
equity against
ROE
for
two
representative groups of companie
s.
The
ROE
figure used
is
a
we
ighted-average
•
■
52
Part
One
A
sr
es
si
11
g
th
e Fi
11a11
cia
l HMlth of the Firm
ROE
over
the
most
recent
three
years.
The
solid
line
in
each
figur~ is a
regre
~~i
on
line
indicat
i
ng
the
gene
r
al
relat
i
on
between
the
two
variable
s.
The
no
_
t1ceable
po
s1
t
1v
e
r~l
a-
tionship
visible
in
both
graphs
suggests
that
high-ROE
compa
_
nies
t~nd
to ha
ve
hi
gh
stock
prices
relative
to
book
value
,
and
vice
versa
.
Hence
,
working
_
to increase
ROE
a
p-
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
interestin
g.
It
shows
the
importance
of
fa
c
tors
other
than
ROE
in
determining
a
company's
mark
et-t
o-
book
ratio
.
As
we
s
hould
expect
these
other
factors
play
a significant role
in
dete
rmi
n-
ing
the
market
value
of
a
company's
shares
.
For
interest,
I
have
indicated
the
positions
of
several
companies
on
the
graph
s. Note
in
Figur
e
2.1
that
Ametek
is
virtually
on
the
regression
line,
indicating that
based
pu
rely
on
historical
ROEs,
Ametek's
stock
is
fairly
priced
compared
to
those
of other
el
ectrical
and
elect
r
onics
companies
..
In
Figure
2.
2,
Pfizer
, a
leading
drug
company,
and
Anheuser
-
Busch
take
the
pr
iz
e wi
th
RO
Es
of
almost
40
percent
although
Gillette
wins
market-to-book
honors
at al
mos
t
16
ti
mes
.
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" a
mo
ng in-
vestors
who
assign
it a
mediocre
market-to-book
ratio
.
Evidently,
investors
are
skeptic
al
that
the
company
can
continue
such
performance
.
Note
too
the
difference
in
s
cale
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
nothin
g
special.
_
Investors
a?pear
not
terribly
enamored
about
the
prospects
for
ele
ctrical a
nd
electroni
cs
companies.
To
summarize
,
these
graphs
offer
tantalizing
evidence
that
despite
its
weak
ness
es
,
ROE
may
serve
as
at
least
a
crude
proxy
for
share
price
in
measuring
fi
na
nc
ia
l
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
..
jA
crosc
ic
nce
•
•N~:
..
Donaldson
Dcw~y
0 I
I
I
I
I
I
I
I
I
O
S
W
U
W
~
M
ll
•
Weighted
av
erage
rc1um
on
equi1y
(%)
Th
e regression equation
is
MVIBV
=
l.lJ
+
8.5
ROE,
where M
V/
BV is
the
mark
et value
or
e
quity
relative
to
the
boo
k
value or equity and
ROE
is
a weighted average
or
return
on
equity
in
Z
OO!
and
the
pri
or two years.
