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Financial ratios are both a blessing and a curse. As a fast tool they can help determine the relative or absolute value of a company and determine whether it would be worthwhile to dig deeper or ignore a company completely. However, because these ratios are so accessible, they are often over relied upon and simplify a company's operations into just a few variables. This often leads to superficial analyses and ignorance of crucial information. The commonly drawn upon P/E Ratio and EV/EBITDA multiple are prime examples of tools that can mislead investors by making investments appear more or less attractive than they actually are.

P/E Ratio

P/E Ratios are the go-to indicator of whether or not a company can be quickly labeled "cheap" or "expensive." By taking the price and dividing it by earnings you get an easy measure of how much money a company makes relative to its peers. Unfortunately, for how often this metric is called upon, it hardly reflects the proper value of a business.

I will lay out my gripe with P/E ratios by using Microsoft (NASDAQ:MSFT) as a quick example. Just with a glance at Google Finance, Microsoft appears to be trading at a P/E of 15.44. If I had used a value-based stock screener to find stocks trading with prices below 10 times earnings, I would have already accidentally cut Microsoft off from my results.

With Microsoft, the short-sighted nature of the P/E metric becomes obvious. In the most recent quarter, Microsoft took a $6.2 billion write-down related to the acquisition of a company called aQuantive that they bought in 2007. In the accounting world, this charge came as a lump-sum and cost Microsoft about 79 cents a share last quarter. In the real world, Microsoft probably weathered the cost of this poor acquisition over the last five years. This means that the charge would have only really affected the last four quarters' earnings by 1/5th of $6.2 billion as most of the damage had already been done. (If it was possible, the asset should have really been depreciated over these five years.) In this case, the P/E Ratio is grounded in current earnings and fails to take a look at the historic picture. Because of the way accounting charges are handled, the P/E ratio makes Microsoft look expensive now while in the previous four years it actually made Microsoft look cheaper than it actually was!

In another shortcoming with this ratio that is much more obvious, P/E does not reflect how past earnings have been carried forward on the balance sheet. In the past few years, Microsoft has been retaining more earnings that have not been reinvested into top-line growth, share buybacks or dividends. With just a glance at the P/E ratio it's impossible to see how this money has been discounted compared to the intrinsic value of the company. Because this cash hoard is not earning a return, it's fair to cut it out of the stock price to make the P/E ratio a pure view of the underlying business.

So given all this information about Microsoft we could probably say the charge on aQuantive was only about 20 cents this year. We could also discount Microsoft's $60 billion of cash at 80%. (Let's assume Microsoft puts 20% of their cash hoard towards more acquisitions like aQuantive.) Using napkin math, this would give us an adjusted price of around $25 and EPS of 2.50. Does this new superficial P/E measure look more attractive now? What if Microsoft never uses that cash?

EV/EBITDA

This measure is another common ratio used to quickly value a company in absolute terms. This ratio takes a company's total enterprise value (market value + debt - cash) and divides it by its earnings before interest, taxes, depreciation, and amortization. This measure is meant to remove any leverage from the equation and value all capital in the company by the company's underlying business operations.

There are a few major problems with this valuation metric; however, there is always one startling fact about this equation that is generally ignored in the case of pure equity investing. EV/EBITDA fails to portray whether equity holders or debt holders are receiving the lion's share of business proceeds. An extreme example of where this is important would be Cablevision (NYSE:CVC). Cablevision has an attractively low EV/EBITDA of 6.84 which shows their operations are bringing in a lot of money. However, their debt load comes in at $11 billion and in the last year their interest expense was slightly over $730 million. Given EBITDA of $2.2 billion, there is not that much left over for the common shares. In this case, EV/EBITDA shows that Cablevision has a great underlying business. But, the ratio does not show the level of leverage and how much an investor would actually benefit from a pure equity investment.

Why P/E and EV/EBITDA

I choose to highlight these two ratios because they both share a shortcoming in their ability to put weight on the value of a company's balance sheet. Although both of these measures are aimed at evaluating the core business rather than the makeup of the balance sheet, in the examples outlined, it is clear that the composition of the balance sheet has a profound impact on what P/E and EV/EBITDA actually tell you.

Obviously there are other metrics that should be used alongside both P/E and EV/EBITDA when valuing a company. Some of these measures such as Return on Equity have their own shortcomings. In a future article I will delve more deeply into problems with P/E, EV/EBITDA, and other valuation tools. As is made clear in this article, performing in-depth analysis is a must as any given valuation technique has its own bias.

Source: Getting Tricked By Financial Ratios: Microsoft, Cablevision