How do returns on capital affect stock prices?

For many years, the use of price-to-book (P/B) ratio has been widely associated with finding bargain stocks, because of the market notion that a stock becomes very cheap when its share price falls below its book value.

We also know that a stock with high return on equity (ROE) tends to have higher P/B ratio, while stocks with low ROEs tend to fall below their book values.

While this correlation appears logical, the problem with this approach is that companies can also use creative accounting to manipulate their ROEs.

If companies want to increase their ROEs, they can simply borrow money to buy back their shares in the market. By buying back, they can decrease the book value of their shareholders’ equity to boost returns.

Company owners can also use off-balance sheet financing to hide their expenses in the business. Lower expenses can increase their net income, which enhances their ROEs.

Because of these limitations, instead of focusing on returns generated by equity, a better measure is to focus on returns created by the total invested capital of the business, which can not be easily distorted by capital structure.

We discussed in this column last week that if we divide the after-tax operating profits of a business by its invested capital, which is the sum of its net debt and shareholders’ equity, we can derive the return on invested capital, or ROIC of a company.

If ROE is correlated to the P/B ratio of a company, we can also correlate the ROIC to the enterprise value-to-invested capital (EV/IC) ratio.

By comparing the EV/IC of a stock to its P/B ratio, we can get a better story of the company, as well as opportunity to identify potential value investing.

For example, if we look at P/B ratio of Meralco, we will find that it is currently trading at four times its book value, which is relatively high, because it has also high trailing ROE of about 21 percent.

But if we are going to look at its EV/IC ratio, we will find the stock is trading only 0.99 times its invested capital.

This is because Meralco’s ROIC is lower at 14.4 percent, not to mention that it also has a high cost of capital, or WACC, which yields the stock a spread of only 4.9 percent.

Another example is the low P/B ratio of Phoenix Petroleum, which trades at 15 percent discount to its book value. The stock has P/B ratio of only 0.85 times because its trailing ROE is also low at 2.5 percent.

But if we consider the total capital of the business, we will find the stock’s enterprise value is trading at a premium over its invested capital with EV/IC ratio of 2.04 times

Again, the reason for the high enterprise value multiple can be traced to the stock’s high ROIC of 9.2 percent, which also yields a positive spread of 6.2 percent over its WACC.

Historically, the average ROIC of the Philippine Stock Exchange (PSE) Index has been moving in tandem with its average EV/IC ratios with a strong 46.5 percent correlation.

This means that a higher average ROIC among PSE index stocks can result in higher stock prices, hence higher EV/IC ratios in 46.5 percent of the time.

In the same way, a lower average ROIC can also result to lower EV/IC ratios. A declining ROIC in the past years also mirrored the decline in the average EV/IC ratio since 2012.

From a high of EV/IC ratio of 2.0 times in 2013, the gradual decline in the average ROIC has brought down EV/IC ratios to 1.34 in 2019.

When the coronavirus pandemic broke out last year, the average EV/IC ratio fell further to 1.29. Today, with a slowing economy and lower ROIC, our average EV/IC is down to only 0.99 times.

While a low EV/IC ratio may mean that stock prices are attractively low, it also tells us that the market’s expectations about returns, or ROICs in the near-term are also low.

It may perhaps take some time before the average returns of companies can fully recover along with the economy, but this must not discourage us from investing, for when there is crisis, there is opportunity. INQ

Henry Ong is a Registered Financial Planner of RFP Philippines. Stock data and tools provided by First Metro Securities. To learn more about investment planning, attend 88th batch of RFP Program this March 2021. To register, e-mail [email protected] or text at 09176248110