Analysis of the P/E ratio
The P/E valuation metric: This is by far the most popular valuation and it is simply dividing the market cap by net income (for the year), it can also be calculated by dividing the share price by eps, the lower the p/e the better, as you are having to pay less for the earnings. Generally, a company is considered expensive with a P/E of over 30 and cheap with a P/E of less than 15.
The main advantage of p/e is that it provides a quick and simple way of finding how many years would you have to wait to get your money back from the investment.
There are however, numerous drawbacks of the P/E ratio:
1. It does not factor in how quickly the earnings are growing. Whilst the earnings may look small in comparison to the price now, if the company is quickly growing in the future the earnings could look large in comparison to the market cap.
2. A one-off loss or gain could distort the earnings to look smaller or larger than they actually are and thus not giving an accurate representation of how richly the companies earnings are being valued.
3. It does not factor in how indebted a company is. A company can easily boost eps, by simply acquiring another profitable company and then using debt to finance the acquisition. The end result is that net income is boosted without diluting the shareholders. So a cash rich company should be rated more highly than an indebted one, as the cash rich corporation can use that cash to boost eps through acquisitions.
4. It does not factor in how cash generative the business model is, a company can be producing plenty of net income, but if the company is not converting it into cash it will be harder to create value for the shareholders.
5. The P/E ratio can be skewed for cyclical companies and earnings could be temporarily depressed or inflated, but this is not actually to do with the actual company itself is doing, but just the nature of cyclicals.
6. Earnings could also be skewed by events that impact trade. Most notable is a black swan event, of which Coronavirus is the latest event. It can however be more subtle than that, for example in 2018 British bowling alley operator Hollywood bowl had trading impacted after England did very well in the World Cup, people had sources of entertainment by watching England and so less people went bowling than otherwise.
It is also worth noting that there are actually several types of P/E ratio. Mostly the P/E is compared to last years earnings, but you can also have forward P/E ratios. When people talk about forward a P/E ratio they almost always mean next years, however it can also be meant for years in the distant future for example forward 2030 earnings. It is worth noting to take forward estimates with a pinch of salt, they are usually overly optimistic and there is no guarantee that these earnings will be the same (or even near) to the earnings, so I would prefer sticking to past earnings as these are more reliable.
It is also worth noting that whilst I have said that P/E = share price / eps it is worth noting that there is not one eps but two. In a company’s income statement, you will have basic (undiluted) eps and diluted eps. Undiluted eps is simply net income divided by total number of shares outstanding. However, diluted eps is slightly different in that it uses the number of shares when all convertible securities (such as convertible bonds or stock options) are converted into shares.
I would recommend using undiluted eps as although earnings may be constant your earnings will look less and less as these securities are converted into shares. It is also worth noting that if you use market cap / net income, you have used the same as share price / basic eps, but I would recommend to actually use diluted eps, after all the share price can decrease even if the market cap increases, I.e. if your stake gets smaller.
The main advantage of p/e is that it provides a quick and simple way of finding how many years would you have to wait to get your money back from the investment.
There are however, numerous drawbacks of the P/E ratio:
1. It does not factor in how quickly the earnings are growing. Whilst the earnings may look small in comparison to the price now, if the company is quickly growing in the future the earnings could look large in comparison to the market cap.
2. A one-off loss or gain could distort the earnings to look smaller or larger than they actually are and thus not giving an accurate representation of how richly the companies earnings are being valued.
3. It does not factor in how indebted a company is. A company can easily boost eps, by simply acquiring another profitable company and then using debt to finance the acquisition. The end result is that net income is boosted without diluting the shareholders. So a cash rich company should be rated more highly than an indebted one, as the cash rich corporation can use that cash to boost eps through acquisitions.
4. It does not factor in how cash generative the business model is, a company can be producing plenty of net income, but if the company is not converting it into cash it will be harder to create value for the shareholders.
5. The P/E ratio can be skewed for cyclical companies and earnings could be temporarily depressed or inflated, but this is not actually to do with the actual company itself is doing, but just the nature of cyclicals.
6. Earnings could also be skewed by events that impact trade. Most notable is a black swan event, of which Coronavirus is the latest event. It can however be more subtle than that, for example in 2018 British bowling alley operator Hollywood bowl had trading impacted after England did very well in the World Cup, people had sources of entertainment by watching England and so less people went bowling than otherwise.
It is also worth noting that there are actually several types of P/E ratio. Mostly the P/E is compared to last years earnings, but you can also have forward P/E ratios. When people talk about forward a P/E ratio they almost always mean next years, however it can also be meant for years in the distant future for example forward 2030 earnings. It is worth noting to take forward estimates with a pinch of salt, they are usually overly optimistic and there is no guarantee that these earnings will be the same (or even near) to the earnings, so I would prefer sticking to past earnings as these are more reliable.
It is also worth noting that whilst I have said that P/E = share price / eps it is worth noting that there is not one eps but two. In a company’s income statement, you will have basic (undiluted) eps and diluted eps. Undiluted eps is simply net income divided by total number of shares outstanding. However, diluted eps is slightly different in that it uses the number of shares when all convertible securities (such as convertible bonds or stock options) are converted into shares.
I would recommend using undiluted eps as although earnings may be constant your earnings will look less and less as these securities are converted into shares. It is also worth noting that if you use market cap / net income, you have used the same as share price / basic eps, but I would recommend to actually use diluted eps, after all the share price can decrease even if the market cap increases, I.e. if your stake gets smaller.
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