Valuation Multiples - PE ratio

Oct 30, 2010

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We are going to run through a few valuation multiples in the next few posts that are used to compare different companies, and the different strengths and weaknesses of each multiple for analysing companies. The ratios we will look at are the P/E, P/B, P/Sales, PEG and EV/EBITDA ratios. First up is the PE ratio.

P/E ratio

The P/E ratio is the most commonly used ratio by most non-professional investors to compare companies and assess value. The P/E ratio is the ratio of the price per share of a company compared to the accounting earnings per share of a company. Professional Investors will often look at both a historical P/E and a forward P/E. The historical P/E is the ratio of the last full year's earnings per share to the current share price, and the forward P/E is the ratio of the projected earnings per share of the company for next year compared to the current share price.

There are a few problems that the P/E ratio is susceptible to. These include the following:

• Data providers usually will show you a historical P/E ratio, and generally read the NPAT number straight off the Profit & Loss statement. This means that if a company had once-off items in the last year included in NPAT then the ability of the company to generate profits on a continuing basis may be overstated in the P/E ratio.
• Earnings are often not representative of the cash generating capability of a company. Companies often need to invest substantial amounts in working capital or in new capital assets in order to support existing sales and sales growth. In the long run these cash investments may be returned to shareholders (via a release of working capital or via depreciation or the sale of assets in the case of fixed assets), however there is still a net present value detriment as the cash is only received far in the future.
• Current Price per share may overstate the actual value per share due to future dilution from options and convertible debt and preference shares. Data providers (generally) look up current shares on issue to calculate earnings per share, but this doesn't include any adjustment for options that are in the money, or any adjustment for debt or preference shares that are about to convert to equity.
• Growth companies will often trade on very high PE ratios, and this can be justified due to the fact that they will generate much larger profits in the future. This means that when comparing these companies to much more established companies will make them appear as a much worse value investment.

So what factors do you want in place in order to use the PE ratio?

• The PE ratio can be useful for comparing companies that are well established, for which both earnings and future growth rates are relatively capable of being predicted.
• The PE ratio is suitable for companies that don't have complex incorporation structures.
• The PE ratio is suitable for companies for which there is a reasonable correlation between earings and cash flow.
• The PE ratio is suitable for comparing companies that are in the same industry.
• The PE ratio is suitable for companies that have a similar capital structure (mix of debt, equity, hybrids etc).