Here’s a simple question for all of you investing hotshots:
Why don’t market returns track ROE?
In other words, if ROE represents the return on the common shareholders’ equity in a particular company, then shouldn’t the market (over time) compound at the weighted average of all companies’ ROEs?
If so, then why is has the S&P500 compounded at 8-10% (depending on if you reinvest dividends) and the average through-the-cycle ROE on the same group of companies has been ~13%?
This is because P/B is over 1x. Price/share and BV/share are the respective denominators in market return and ROE, respectively, so when P/B is over 1x, the market return will generally be lower than ROE.
Another way to think about it is that the justified P/B ratio can be expressed as P/B = (ROE – g ) / (r – g), where r is the required rate of return. When ROE is greater than r, P/B is greater than 1x.
That’s just the math. What that is saying is that investors’ required return is lower than what companies are earning.
I’d say there are a couple factors at play but no.1 is probably the primary:
1a) low rate / cost of capital environment — allows companies to add cheap leverage (reducing BV) and investors are actually paying more for these companies because TINA. (Although adding leverage should also have effect of increasing equity earnings)
2) structural changes in company balance sheets — a lot of what would have been capitalized expenses are now expensed in the period — ie hard asset capex vs technology-building capex— reducing balance sheet / BV
I’d be interested to see exactly what OP is looking at.
What? No.... Think about it. If you buy a stock at 100 with a book value of 50, and it generates $10mm in a year, as an investor your return will be 10% and the ROE will be 20%. It’s really that simple. The first response was correct...
You’re right, we should just stop at the mathematical tautology and not actually try and explain, or even think about, the real world reasons as to why that exists.
I guess to you the reasons economies go into recession is because GDP growth turns negative, and the reason one company’s bonds trade at a higher yield than another’s is because their price is lower?
Yes - I think you’re right. This seems to make the most sense in relation to the difference in cost basis vs. book value.
In other words, because participants in the market are purchasing shares an avg. price >1x BV/share, then returns should be lower than ROE, as they are paying a premium to BV:
If ROE = NI/BV, then if you’re paying over 1x book value for the stock, then the denominator gets larger and ratio smaller overall.
Thanks guys!
Accounting book values have also become disconnected from the true value of equity. A lot of discretionary accounting BS gets routed through book equity these days and non-goodwill intangible assets are often misrepresented on the asset side (understated or overstated). Add in debt for equity buybacks and there you have it. I personally do not use any metrics related to book value anymore.
Exception would be banks.
Thank you, someone else here is engaging on the underlying reasons and not the surface math
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