Can ROE Substitute for Share Price Figures 21 and 22 suggest that the gulf

Can roe substitute for share price figures 21 and 22

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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
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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.
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