almost 2 years ago • 1 min
The above chart shows the relationship between a sector’s return on equity (ROE) – that is, how effectively its companies use their cash to generate a profit – and its valuation, as measured by its price-to-book multiple.
There are a couple of notable things here. For one, you can see that the higher a sector’s ROE, the higher its valuation. Just look at the consumer discretionaries, consumer staples, and IT sectors: they tend to both generate a high net income for every dollar they invest and boast the highest valuation, as opposed to sectors – like financials and utilities – that require a lot more capital to earn the same income. That makes sense: investors are more likely to want to buy into – and in turn push up the valuation of – a company that does more with every cent.
The other thing to note is that the relationship between valuation and ROE is relatively linear. So by looking at a variety of sectors at once, we can draw a line of best fit that indicates what the price-to-book multiple of a sector “should” be based on its ROE. In other words, we can estimate whether a sector is currently over or undervalued.
You can see that consumer discretionaries are trading at a much higher multiple than their ROE suggests, suggesting the sector’s particularly pricey right now. Energy and healthcare, meanwhile, seem to be going particularly cheap. So you might want to short the former and buy into the latter, in hopes of profiting when investors get wise and send the stocks back to what they’re really worth.