One of the book’s maxims is Ignore Information at Your Peril. So investing on the basis of just one piece of earnings in a P/E screen came in for criticism in chapter 2. Adding just one other piece of information, book value, introduces P/B and ROE, as in the chapter. That essentially decomposes P/E (or E/P) into two parts which give additional insights:
E/P = E/B x B/P = ROE x B/P
So a given E/P (P/E) can be any mixture of ROE and B/P, a high ROE with low B/P or low ROE with high B/P, for example.
For the historical average P/E since 1960 of about 16 (E/P = 6.7%) with a P/B of 2.99 (a B/P of 0.334) and an ROE of 20%,
E/P = 6.7% = 20% x 0.334
But an E/P of 6.7% can also be accounted for by
E/P = 6.7% = 5% x 1.34
That is, an ROE of 5% and a P/B of 0.75 (a B/P of 1.34).
Now, as chapter 2 instructs, a high P/B is justified by a high ROE (as in the first calculation here) and a low P/B is justified by a low P/B (the second calculation). The interesting case for a value investor is that with a high ROE and a low P/B. It suggests the market is underpricing the ROE: Why is the P/B so low while the book value is generating a high return on book value? See also the testimonial on a P/B-ROE strategy on this webpage.
There is a Vignette in chapter 2 pointing to some interesting cases. Here are the subsequent returns over one year and two years for the firms exhibited there. Note that for Newell Brands and China Eastern, the second year ahead was the Covid pandemic year.
| Firm | 1-year Return | 2-year Return |
|---|---|---|
| Newell Brands (NWL), 2018 | 71.2% | 72.5% |
| China Eastern Airlines (CEA:NYSE), 2018 | -2.5% | -2.3% |
| General Motors (GM), 2022 | -6.7% | 30.3% |
| Goodyear Tire & Rubber (GT), 2022 | 24.4% | 8.5% |
| Goldman Sachs (GS), 2022 | 7.8% | 53.8% |
This is not a completely informed strategy for three reasons.
First, it’s not current ROE that the P/B prices but expected future ROE. So look at the forward ROE but, even then, ROE in later years also matter.
Second P/B is not only based on expected ROE but also the amount of investment that the firm puts in place to earn the ROE; more investment to earn at a high ROE adds value. The two generate growth.
Third, expected ROE needs to be discounted for risk to ROE. That affects the price in P/B. If expected ROE is high but at risk of falling a lot, price should be lower.
These are the additional features to the P/B-ROE strategy that the book brings in as it proceeds.