Equity Per Share - Not sure what this is

[mpeyrac]

Hi Guys,

I am reading buffettology and i am trying to figure out what return on equity is?

I thought to calculate return on equity it was net profit divided by market capital (shares outstanding)

But for some reason in this book it looks like it is net profit divided by equity (assets - liabilities)

My questions are
1. Is ROE calculated on market cap or equity?
2. How come shareprice can be so much higher than equity per share?
3. Is equity per share = equity per share multiplied by shares outstanding = Book Value?

Im still pretty new to this all so just trying to understand how to calculate all these ratios.

Thanks in advance.
Milan

 

[beerwm]

ROE = Net Profit/Total Equity
Total Equity = Total Assets - Total Liabilities.

from memory

 

[mpeyrac]

cool thanks i have just read that and now makes sense.

Can anyone confirm why shareprice can be so much higher than equity per share?
Also does Equity = book value?


Thanks
Milan

 

[Rainmaker2000]

I would start from the premise that equity per share means almost nothing and build from their.......

A share price has about the same relation to equity per share............as if you did a stock take on your life........and determined what was most valuable.

Chances are you would say 'intangible' things were most valuable like your family and relationships..........just like a company has goodwill and brands........

You would then start thinking about the laptop computer you bought four years ago for $4 000 which you may value at $4000 but if you tried to sell it it would be worth $20......

Same considerations go into valuating the assets of a company

 

[skc]

cool thanks i have just read that and now makes sense.

Can anyone confirm why shareprice can be so much higher than equity per share?
Also does Equity = book value?


Thanks
Milan

Equity is recorded at historical value in the accounts. Share price is the current market value.

ROE is calculated on the historical price so you know how much profit the company makes for the equity they have received. E.g. a company has an IPO of $1 for 20m shares, they have $20m to make profits from.

The share market on the other hand is a secondary market and has no bearing on what the company has access to in terms of $$.

Share price can be substantially higher than equity because the company has successfully grown that initial equity into more and more earnings. It's like a compounding effect within the company (e.g. look up plow back). Obviously share price is also driven by emotions of the crowd that is not reflected in the accounting entry of book value.

For your own investment purpose however, looking at ROE based on your own equity (i.e. the share price you've paid) would tell you whether the investment is worthwhile.

 

[mpeyrac]

hey SKC,

When you say ROE that i have payed, would i be right in saying you can work this out by taking EPS and dividing it by the price you bought 1 share at to work out your own ROE?

 

[jono1887]

ROE is calculated on the historical price so you know how much profit the company makes for the equity they have received. E.g. a company has an IPO of $1 for 20m shares, they have $20m to make profits from.

But there are other ways of them obtaining funds. If they dont give out dividends and if they release corporate bonds then they would have a much higher level of equity than their historical price. You would have to check their most current balance sheet to work it out.

 

[beerwm]

just on a side note;

I dont think ROE[or most other accounting details] require much consideration when purchasing shares. Unless like buffer you are looking to take a large stake in a company.

my 2cents.

 

[jono1887]

hey SKC,

When you say ROE that i have payed, would i be right in saying you can work this out by taking EPS and dividing it by the price you bought 1 share at to work out your own ROE?

What Does Earnings Per Share - EPS Mean?
The portion of a company's profit allocated to each outstanding share of common stock. Earnings per share serves as an indicator of a company's profitability.

Calculated as:


I dont think its the same as ROE.

 

[skc]

hey SKC,

When you say ROE that i have payed, would i be right in saying you can work this out by taking EPS and dividing it by the price you bought 1 share at to work out your own ROE?

Yes. That's the way Buffet works it. However, a basic premise is that market will value the stock and reward growing EPS with higher share price.

What Does Earnings Per Share - EPS Mean?
The portion of a company's profit allocated to each outstanding share of common stock. Earnings per share serves as an indicator of a company's profitability.

Calculated as:


I dont think its the same as ROE.

Nobody saying EPS is the same as ROE. ROE (for you as investor) = EPS / price you paid.

But there are other ways of them obtaining funds. If they dont give out dividends and if they release corporate bonds then they would have a much higher level of equity than their historical price. You would have to check their most current balance sheet to work it out.

Corporate bonds are not equity. It is called debt.

just on a side note;

I dont think ROE[or most other accounting details] require much consideration when purchasing shares. Unless like buffer you are looking to take a large stake in a company.

my 2cents.

ROE doesn't require consideration for technical analysis. But ROE is the most important measure if you are buying shares on a business' fundamental. Given EPS is $1 for the next 20 years, would you pay $10 a share or $5 a share? Clearly a lower price has a higher ROE. Or put other way around, if you demand a high ROE you will only buy it at the lower price.

This is true whether you buy 1 share or 50% of a company.

Who's buffer btw?

 

[alphaman]

Corporate bonds are not equity. It is called debt.

If a company pays out nil dividends and uses the cash to buy back the bonds, both equity and net income would increase, which would change the ROE, although it is the same company, just with a different capital structure. I think that's what he's trying to say.

 

[mpeyrac]

Thanks for that SKC!

So just quickly with ROE, after reading buffetts book i have learnt that if ROE is growing at say for example 15%. net income is increasing at 15% and all earnings are being retained by the company, then that means EPS is growing at 15% which in effect would reflect in the shareprice rising. Shareprice = EPS X average PE?

Is the above correct?

 

[skc]

Thanks for that SKC!

So just quickly with ROE, after reading buffetts book i have learnt that if ROE is growing at say for example 15%. net income is increasing at 15% and all earnings are being retained by the company, then that means EPS is growing at 15% which in effect would reflect in the shareprice rising. Shareprice = EPS X average PE?

Is the above correct?

Correct. But you don't come across growing ROE that much I don't think.

Remember in the ROE equation (for the company), E includes retained earnings.

If company pays no dividend, retains all earning and reinvest into the company then EPS will grow at the same rate as the current ROE.

Say a company with current E of $1m, ROE of 15%, and has 1 share
Year 1. E = $1m, ROE = 15%, EPS = $0.15m
Year 2. E = $1.15m, ROE = 15%, EPS = $0.1725m
Year 3. E = $1.3225m, ROE = 15%, EPS = $0.1984m
and so forth...

Say a PE multiple of 10, the share price would be $1.5m in year 1, $1.725m in year 2 and $1.98m in year 3.

If a company can grow the ROE in addition to the growth in EPS, then the growth in EPS and share price would be exponential. Using same example:

Year 1. E = $1m, ROE = 15%, EPS = $0.15m
Year 2. E = $1.15m, ROE = 17.25%, EPS = $0.1984m
Year 3. E = $1.3484m, ROE = 19.84, EPS = $0.2675m
and so forth...

So you probably only need a consistent / slightly rising ROE. Difficult to find a sharply rising ROE unless they really nailed some sort of monopoly.

Best do a spreadsheet and see the effect for yourself.

The calc is always simple. The hardest part is predicting earnings.

 

[mpeyrac]

Hi SKC,

I see what you are saying below and i understand everything except the part where you say company can grow EPS and shareprice exponentially.

Year 1. E = $1m, ROE = 15%, EPS = $0.15m
Year 2. E = $1.15m, ROE = 17.25%, EPS = $0.1984m
Year 3. E = $1.3484m, ROE = 19.84, EPS = $0.2675m
and so forth...

Not sure how you got these figures above? would u mind explaining? Thank you so much for your patience.

 

[skc]

Hi SKC,

I see what you are saying below and i understand everything except the part where you say company can grow EPS and shareprice exponentially.



Not sure how you got these figures above? would u mind explaining? Thank you so much for your patience.

In the example I just tried to illustrate what the share price look like if a company grow the ROE at 15% per year.

So ROE changes from 15% in year 1, 17.25% (15% x 1.15) in year 2 etc. EPS is simply calculated by the E x the ROE.

A constant ROE means a company make same return per dollar, but the EPS and share price grow because the company has more dollars to make returns from. A growing ROE on the other hand means the company needs to drive $1 harder every year.

As you can see this is hard to come by and probably can't last very long.

 

[mpeyrac]

Thanks SKC for your thorough input. Much appreciated.