How Stocks Work

Felix Salmon put three questions to Jim Surowiecki on the mechanics of stock valuation. I have some differences with Surowiecki’s answers so here’s my take:
Felix Salmon: What’s the relationship, in theory, between a company’s return on equity, on the one hand, and its stock price, on the other? Does a high return on equity mean a rising stock price, or is it a rising return on equity which means a rising stock price? Or, to put it another way: if one company has an ROE which is (expected to be) flat at 4%, and another company has an ROE which is (expected to be) flat at 14%, would you expect the latter to rise more than the former, or indeed either of them to rise at all?
Eddy: A company’s share price is the net present value of all future cash flows. A company’s return-on-equity is a measure of profits for the next year relative to present equity, so the two are connected. However, a high ROE does not translate to a rising share price, but a rising ROE should. Regarding your question, I would assume that the market has discounted both stocks’ net present value which incorporates ROE. Therefore, I would only expect the stocks to rise at the pace of the risk-free rate plus the equity risk premium.
This may help: ROE can be broken down into three parts; profit margin, asset turnover and leverage. It goes like this:
Profit margin is earnings divided by sales. Asset turnover is sales divided by assets. Leverage is assets divided by equity.
Earnings……….Sales…………..Assets
—————X—————-X————–
Sales…………….Assets………..Equity
Note that the sales and assets cancel each other out to give you Earnings divided by Equity.
FS: What’s the relationship between stock price, ROE, and risk-free rate of return? Would one expect ROEs in a country with a zero risk-free rate to be lower than ROEs in a country with a higher risk-free rate? How does that feed in to stock prices, if at all?
Eddy: Again, a company’s share price is the net present value of all future cash flows. ROE is the best measure of the growth of future cash flows. How do we discount that? We discount it by the cost of capital which is risk-free rate plus an equity-risk premium. That’s why a lower risk-free rate tends to boost equity prices.
According to the Gordon Model, it should look something like this:
Price = Earnings/(Risk Free Rate + Equity Risk Premium – ROE)
FS: How can a company with a positive ROE destroy economic value for shareholders?
Eddy: All companies in all industries are in phantom competition with the cost of equity capital. Even though you can’t see it, you’re struggling against it every day. So even if a company manages to squeak out positive ROE, capital will not flow your way if you keep losing to everybody else.

Posted by on November 4th, 2008 at 11:15 pm


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