A Critical Assessment of the Relationship between P/E Ratio, RONW and ROCE: A study of FMCG, IT and Banking Sectors

Abstract

Stock investing requires careful analysis of financial data to find out the company’s true worth. Valuation ratios and Return ratios can predict the share price performance, giving investors an opportunity to know if a stock is overvalued or undervalued. Data for the period from 2010 to 2020 is considered for the study. Price- Earnings ratio (P/E ratio), Return on Net Worth (RONW) and Return on Capital Employed (ROCE) for the top five companies in the FMCG, Banking, and IT sectors are taken for the study. The relationship between the identified variables has been analysed using correlation and linear regression techniques. The analysis reflects that there is a positive relationship between the P/E Ratio with RONW and ROCE for most of the companies in all three sectors. While many factors influence the investment decision, the P/E ratio is an important metric to consider. For the companies across the various sectors, it is evident that the ROCE and RONW have a very strong correlation and also exert influence on the P/E ratio. Therefore, a simple linear regression model is used to demonstrate the relationship between the P/E ratio and ROCE and P/E ratio and RONW. For all the companies across the sectors, a positive relationship is reflected between the P/E ratio and RONW and ROCE. It is essential to analyze the ratios together to get a comprehensive understanding of the financial performance of companies.