Valuation not value - When paying a higher price can be justified
We assess a company’s value based on a wide range of characteristics: from growth and profitability, to capital structure, corporate behaviour, ESG metrics, and market sentiment. Companies with an attractive valuation and a positive blend of these elements are what we look for when investing.
A simple way of thinking about how a company’s characteristics interact with one another to create its ultimate value is to consider the relationship between a company’s Price-to-Book (P/B) ratio, a valuation metric, and its Return on Equity (ROE), a measure of profitability.
Broadly speaking, similar companies tend to display a persistent relationship between profitability and valuation: the higher the excess returns the company is expected to generate, the higher the valuation. Looking at figure 1, the lines show how different levels of profitability are valued in each industry group, with companies below the line for a given sector looking cheap and those above the line expensive. From the slope of the lines we can estimate the market’s expectations of how long companies in each industry are expected to deliver excess returns. This is referred to as the market-implied competitiveadvantage period for the peer group.