Risenhoover's  Instablog

The P/E ratio, or Price to Earnings ratio, is a valuation ratio that is used by a large part of the investing community.  Unfortunately, it is a terrible ratio to use, for a lot of reasons, and we are going to show you why.  Technically, it is the current market share price divided by the Earnings per Share of the company (usually the trailing twelve months). The resulting number is a multiple that indicates the number of years it will take for the earnings to pay back the share price.  “Good” and “bad” P/E ratios vary over time.  In overheated markets, a P/E ratio of 20 can be considered extremely cheap.  Today, there are 1400 companies that have a P/E ratio of 20 or less (out of 6116 on the major US markets).

The problem with P/E ratios is that earnings – the part that makes up the “E” – can be managed and manipulated, and companies do this in order to maintain their share prices – knowing that if their earnings drop, their share price will drop.  Earnings per Share is Net Income divided by the total number of shares.  One better measure of economic valuation is Free Cash Flow.  Free Cash Flow tells us the amount of cash generated by a company in each period.  

If we use the RobotDough.com Visual Stock Screener to filter on Net Income > 0 and Free Cash Flow < 0, we’ll see that there are 527 companies reporting positive income but which actually lost cash in the last quarter.  These are companies that would have shown up with a positive P/E ratio.

One way to resolve this issue is to replace Earnings with a better measure of economic activity.  We mentioned Free Cash Flow earlier, but another alternative that is commonly used is EBITDA.  EBITDA is a measure of the earnings generated by the normal operations of the company.  It excludes many of the non-cash expenses such as Interest, Taxes, Depreciation, and Amortization (the ITDA in EBITDA).

Another issue with P/E ratio is the Price part of the ratio – the “P”.  The share price represents the market value of the equity in the company.  This is a proxy for the firm’s valuation.  However, share price does not take into account the value of the debt, which could be substantial in highly-leveraged industries.  To include debt in their ratio analysis, many analysts use Enterprise Value, which includes Market Capitalization as well as total Long Term Debt.

So to summarize, P/E ratio, although it is used frequently in basic ratio analysis, is not the best measure available.  On the RobotDough stock screener, users can use terms such as Enterprise Value, EBITDA, and Free Cash Flow to perform more sophisticated ratio analysis.
 

RobotDough’s mission is to provide sophisticated equity analysis tools to individual investors.  The RobotDough.com Visual Stock Screener is only the first of many such features to launch.  Register today to get a free trial.