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What is value creation?

We often hear people speak about how the stock market can create value for investors. Whereas there are various interpretations of creating value, the simplest one to interpret is where the market value of the company exceeds the total amount that shareholders invested. 

Generally, the market value of a company is referred to as the market capitalisation and is calculated by multiplying the share price by the number of outstanding shares, whereas the amount shareholders invested is simply the assets of the company minus its liabilities and is referred to net asset or book value.
 
Market analysts use the ratio of the market capitalisation to book value as a single measure of value creation and refer to this ratio as the price-to-book ratio or “P/B”.

A company with a P/B ratio of 1 has created no value for shareholders whereas one that has a P/B ratio greater than 1 has created value.

Sometimes, the P/B ratio is less than 1 and we refer to this as a scenario where value has been destroyed. 

At this point, it becomes particularly interesting. It is possible to break down the P/B ratio into two factors that contribute equally to its value. I’ll spare you the details, but one can derive the following mathematical identity that holds true at any particular point in time for any stock:

P/B = P/E x ROE

Where P/E represents the price-to-earnings ratio of the company (this is the number of years it would take to earn back your investment in the company through its current annual profit) and ROE refers to the return on equity of the company, a measure of the annual profit of the company in relation to the amount invested by shareholders in that year of profit.

Unpacking the ambiguity of the P/E 

Most analysts and market commentators make reference to the P/E in relation to the value of the company. A high P/E (say above 15) is usually interpreted as expensive whereas anything less than 10 is considered cheap.

Off course, a company’s profits may change from year to year and a higher growth company usually has a higher P/E associated with it, so one needs to interpret the P/E in the context of the company’s growth in order to make a quantitatively relevant and meaningful assessment of the expensiveness of a company.

The factors that drive the P/E ratio are varied and would include changes in macroeconomic variables such as interest rates, currency exchange rates and GDP growth rates, sovereign credit ratings and fiscal metrics that influence the profitability of the business sector that the company operates in.

There are also company-specific issues that may influence the P/E ratio of a company such as the ability of the company to grow its earnings in excess of that of the sector it operates in.

It is important to understand though that the P/E is largely set by the market and not by the company or its management itself and in fact there is often very little management can do to influence its P/E.

The second factor though, the company’s ROE, is very much in control of the management of the company. The factors that drive the ROE relate to operational and financial efficiencies.

On the operational side, the biggest driver are product mix i.e. being able to market and sell higher margin versus lower margin products and cost efficiencies.

The use of technology to achieve higher productivity of human capital and better logistics management are two standout areas that companies target to grow their ROEs.

On the financial side, the intelligent use of leverage, tax planning, debtor management and business restructuring e.g. mergers and acquisitions can help grow profits of the existing shareholder capital base.

In the current SA environment we operate in, with stagnant GDP growth and high interest rates its wishful thinking, I believe, to expect value to be created by an expansion of P/E ratios, which themselves are stubbornly high compared to history.

The opportunity exists though, for innovative management teams to carefully examine their businesses with a view to expanding their current ROEs to sustainably higher levels, thereby delivering value to shareholders. 

From an investment management perspective, therefore, it is becoming increasingly important to identify those management teams that are focused on delivery value to shareholders by expanding their ROEs.

Nesan Nair is a portfolio manager at Sasfin Wealth.

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