Valuing a stock - ROIC/PE - an interesting ratio
Updated
As I am both a longer term and shorter term investor and trader the notion of the best way to estimate if a stock is undervalued or over valued interests me. There seem to me a number of ways to go about doing this but I was interested to see if I could combine two traditional metrics that people look at into one measure and see if that told me anything interesting.
The two measures I am interested in are P/E ratio - typically used as an indicator of whether a stock is under or overvalued in terms of its price to earnings and of course sometimes reflecting also the expectancy of future earnings growth or reduction.
The second measure I was interested in is ROIC - Return on Invested Capital - a fairly good measure of how well a company martials the capital it has invested into producing returns.
So I decided to start checking a ratio of these two measures for a series of companies.
The ratio I am using is ROIC /PE.
When price goes up if EPS and ROIC are same then this ratio goes lower - and vice versa.
When ROIC goes up if PE and EPS are the same then this ratio goes higher - and vice versa.
When EPS goes up if ROIC and Price are unchanged then this ratio goes higher - and vice versa.
When PE ratio goes up then this ratio goes lower - and vice versa.
I found an interesting interplay of these factors across a range of stocks and ratios varying from below 1 up to in the twenties.
I'm still thinking about what this ratio is really telling me.
Here are two current examples which were correct for prices I think it was early last week.
NVDA
ROIC 12.3 PE 137 ROIC/PE RATIO - 0.09
ON SEMICONDUCTOR
ROIC 22 PE 18.23 ROIC/PE RATIO - 1.22
Based only on this ratio and looking at the ratio for various other stocks then NVDA looks very overvalued compared to say ON Semiconductor. Some stocks cam out with really high ROIC/PE ratios and its left me wondering if these are stocks that are really undervalued.
Of course the confounding factor in this that a high PE may be there because of expectations for strong future growth. But you'd have to have really strong growth in either ROIC or EPS - or a drop in stock price - for NVDA to come into ratios more like other stocks.
Im interested in any thoughts people have on this ratio as a pointer to overvaluation or undervaluation of a stock.
Thanks. ( Its my first public post - be gentle lol.
Note
Update: It strikes me that different industry sectors might have different typical ROIC/PE ratios compared to others. Im going to try analysing from that poitnt of view next I think.
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