IBD Interview Question: The inverse of P/E VS. ROE VS. Levered Return
I got an interview question about the differences of the inverse of P/E VS. ROE VS. Levered Return, not really sure about the conceptual differences among the three?
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my interviewer said that inverse E/P is how much return equity investor is asking to get, then isnt E/P ratio similar to levered return?
I'm not too clear on the question, as I have never heard of inverse P/E.....but, I am willing to bet that it is some metric of earnings yield. so for a $10 Stock earning $1.00 a share, you have a 10% earnings yield, where as ROE is going to be the return on the shareholder equity of the company.
So whereas Earnings yield could be affected by the market price of the stock...it could go up to $12 in the market, but you're still only earning $1.00 a share so you're earnings yield would be lower. You're ROE will be affected by capital structure because the more debt (less equity) in the structure, you'll have higher ROE.
I have no idea what they mean by levered return...if they mean levered vs. unlevered ROE then I'm assuming you just add interest expense back in for the unlevered figure and divide that by your ROE
the exact question the interviewer asked is that a company have a P/E ratio of 20, and cost of debt (net of tax) of 4%, should it choose debt financing or equity financing? I said you need to give the levered return (Re in the WACC equation) and compare it with cost of debt net of tax to decide which one to use, but the interview said that inverse P/E, aka the earnings yield, is what the investor is asking for return. So that's why I was wondering if earnings yield can be a proxy of levered return?
That's pretty interesting. I believe what the interviewer is saying is that PE is what his proxy is for Cost of Equity. So your answer would be something along the lines of a stock with a PE of 20, and EPS of $1.00 would have an earnings yield of 5%, if that is considered to be your Cost of Equity, then your after tax Cost of Debt would be cheaper to raise at 4% than your cost of equity.
Essentially what they are saying is that the earnings yield is your cost of equity
Yeah, I've never heard that earnings yield is the same as cost of equity, or earnings yield is not exactly the same as cost of equity but can be a proxy of cost of equity?
Cost of Equity is actually always just an estimate. It was my understanding (could be wrong) that best practice was to use CAPM to estimate your cost of equity, but maybe I am wrong / in practice it is done using earning yield. The specific bank you interviewed with could just use that method, it would be quicker than building out a CAPM model for your CoE.
Intuitively thinking about it, earnings yield does make some sense as for the markets required cost of equity, because your PE is just what each investor is willing to pay per dollar of earnings, and the inverse of that is theoretically a yield that investors are willing to accept for the equity in that business.
Yeah agreed thank you sooo much!!!
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