The P/E Ratio: Fallacies and Foolishness
One of the most common valuation metrics is the P/E ratios, yet the widespread misintepretation can be very dangerous. Lets first discuss the components that compose this ratio followed by potential dangerous it may convey.
The ratio is the current market price/eps of P/Feps. Since this is used for equity analysis, it is neccessary then to include cash, marketable securities and interest bearing debt. In other words price alone is insufficient and must be adjusted by taking the (current market value of equity - cash + debt), also known as enterprise value(divide this by shares outstanding to get the enterprise value per share). This is a much better alternative because it will adjust the numerator accordingly which will eliminate distortions.
For those who don't know what the intrinsic value of any asset is to be: remember "THE VALUE OF ANY ASSET IS THE PRESENT VALUE OF ALL THE FUTURE FREE CASH FLOWS PRODUCED THROUGHOUT ITS LIFETIME." Earnings or EPS is not a measure of profitability! Thats right people EPS does not measure profitability for a few reasons......This is done best by first giving examples.
1) Lets say for example a company earned 200m after tax, with 100m shares out. EPS therefore is $2. But say the company must reinvest 25 million every year to replenish inventories (increase in non-cash working capital) in addition to another 125 million for new machinery (plant,property,equipment). In this case the net income available to common shareholders is 200m - 25m - 125m = 50m. In otherwords in order to keep the company operating the EPS after reinvesting the neccessary capital is .50 cents.
2) Even More Common is the excitement over growth companies i.e they will grow revenue and earnings 100% for the next 2 years. For fast growing companies, almost all or even more than current earnings need to be reinvested in order to grow the next year.
Conclusion: The P/E ratio is very flawed but luckily there is a much more accurate variation: EV/FCF (enterprise value/ free cash flow)/shares out.
* If the speedy company earned 200 million after tax, needs 25 million for an increase in non-cash working capital and 75 million in capital expenditures. Speedy has 25 million in cash and 225 million in debt. It is trading at 10/share with 100m shares oustading.
== EV= (20*100m)-25m+225m= 2200m
== Free-cash flow = 200m -25m - 75m= 100
P/FCF = (2200/100)= 22
P/E= 2000/200= 10
I think people may think twice buying a stock if the P/E was 22 as opposed to 10..
This is a brief and simplified example as i left out the effect depreciation expense has, aquisiions, what change in non-cash working capital is, etc. But this is useful for the reasons I stated above. This can also be done using forward p/fcf if you can project growth and cap-ex.