Comments on: Quantitative Analysis is not Trivial — The Case of PB-ROE

By: David Merkel

David Merkel — Sun, 08 Jul 2007 07:26:00 +0000

OK, your math is right as far as it goes. So long as the intercept of the regression equation is near zero, PB-ROE and low P/E investing are similar. There are times in the market when book value is prized, and times when earnings growth is prized. In both cases, the intercept will not be zero.

Paul, thanks.

BriG, thanks also. He may have been trying to give a stylized example. Ed Spehar’s note had more data behind it.

By: OK

OK — Sun, 08 Jul 2007 07:08:14 +0000

(P/B)/(E/B)=P/E? No?

By: BriG

BriG — Sun, 08 Jul 2007 03:10:20 +0000

Ok I took a second look and figured out the discrepancy. Mr. Maxfield rigged his example by using the same book value for all 3 companies. When it comes to linear regression 2by3 isn’t the same as 4by6, or 6by9.

He was trying to claim from a purely mathematical standpoint that they were the exactly the same(PB-ROE vs P/E), but clearly that’s false.

By: PaulinKansasCity

PaulinKansasCity — Sun, 08 Jul 2007 02:23:49 +0000

Thanks David for those insights; to say you didn’t you learn to do this in a day is an understatement! Have a great weekend!

By: David Merkel

David Merkel — Sat, 07 Jul 2007 20:20:55 +0000

Paul, if capital is not scarce there are alternative calculations that can be run. One would be to net out excess capital, and run PB-ROE on the adjusted book, with a reduction to earnings from reduced investment income/ increased interest paid, then add the capital back in at the end.

The other way is to figure out what is scarce in the industry. It might be end user demand — at that point substitute sales for book value, and at that point the regression becomes price-to-sales as a function of profit margins.

BriG, you can use any shareholders equity measure you like, so long as it is the same one in both variables. I use trailing book for both. Sometimes I will use it on a tangible basis, and/or ex-FAS 115, but changes both the P/B figure as well as the ROE figure. They have to be kept consistent.

By: BriG

BriG — Sat, 07 Jul 2007 19:38:57 +0000

Trying to get a handle on this, Zach Maxfield it would seem considers the E part of the ROE equation to be equal to current Bookvalue. I assume you’re using Average shareholders’ equity over time to compute the E part?

By: PaulinKansasCity

PaulinKansasCity — Sat, 07 Jul 2007 16:22:57 +0000

I hope Zack reads this; but thanks for the background story. With regard to point 5 I think it could be argued that capital is not scarce currently; it’s really the opportunity/ability to deploy it efficiently! That is where the ability to evaluate management competence is so critical.