Co m pany A B Debt @ 10% interest $ 900 $ 0 Eq ui ty 100 1,000 - - Total assets $1,000 $1,000 EBI T $120 $120 - Interest ex pe nse 90 0 -- -- Earnings before tax 30 120 - [email protected]% 12 48 -- -- Earnings after tax $ 18 $ 72 RO E 1 8.0% 7.2% ROA 1.8% 7.2% ROIC 7. 2% 7 .2% - - The Va l ue Problem ROE measures the return on shareho l ders' investment; howev er, the in - vestment figure used is the book va lue of shareholders' equity, not the mar- ket value. This distinction is important. Ametek's ROE in 2001 was 19 .7 percent, and i ndeed this is the return you cou ld have earned had yo u been able to bu y the company's equity for its book value of $33 S. l mrnion. But that would have been impossible, fm , as noted in the previou s chapter, the market value of Arnetek's equity was $1,046.5 million. At this price, yo m

.---- 50 Pan One Amssi11g tb e Fi11ancinl H rn lth of tb e Fm11 annual rerurn would have been only 6.3 percent, not 19. 7 perc e nt ($66.1/$1,046.5 = 6.3 % ). The market va lu e of equity is more significant to shareholders because it measures the current, realizable worth of the shares, while book value is only history. So even when ROE me asures management's financial performance, it may not be synonymous with a high return on investment to shareholders. Thus, it is not enough for investo rs to find companies capable of generating high ROEs; these com- panies must be unknown to others, because once they are known, th e pos- sibility of high rerurns to investors will melt away in higher stock pri ces. The Earnings Yield and the PIE Ratio It mi~ht appear that we can circumvent the value problem by s imp ly replacing the book va lue of equity with its market value in the RO E. But the resulting earni ngs yield has problems of its own. For Ametek, Net income Earnings yield = Market value of sharehold ers' equity _ Earnings per share= $2.01 = 6 _ 3 % - Price per share $31. 89 Is earnings yield a useful measure of financial performance? N o! T he problem is that a company's stock price is very sensitive to investor ex- pectations about the future. A share of st ock entitles its owner to a p or tion of future earnings as well as present earnings. Naturally, the higher an in- vestor's expectations of future earnings, the more she will pay for the s tock . This means that a bright future, a high stock price, and a low earn- ings yield go together. Clearly, a high earnings yield is not an indicator of superior performance; in fact, it is more the reverse. Said another way, the earnings yield suffers from a severe timing problem of its own that invali- dates it as a performance measure. !urning the ~arnings yield on its head produces the price-to-earnings rat10, or PIE ratio. Ametek's 2001 PIE ratio is Price per share $31.89 Earnings per share= $2.01 = 15.8 times !he _PIE ratio adds_ little to our discussion of performance measures, but its wide use among investors deserves comment The PIE . .