We have mentioned the P/E ratio and how it is widely used to evaluate stocks and indices. In our previous post, we used it to evaluate the market as a whole to get a feel for if Mr. Market is overvalued, neutral or undervalued. This time, we can take a look at it on a company level and see how it works compared to other methodologies.

P/E = Price divided by Earnings. Price would be the price of the stock and earnings would be the earnings of the stock. Earnings is the Net Income of the firm after all expenses including interest payments. Pretty simple right?

Next, P/E ratios can fall under trailing or forward/leading P/E ratios. Trailing uses the earnings of the past 4 quarters and forward P/E uses the estimated next 4 quarters of earnings. You can look at a P/E ratio as the amount of time it will take to recoup/double your investment. A P/E ratio of 10 or stock price of 10 with earnings of 1, or a stock price of 20, with earnings of 2, means it will take 10 years to earn 100%. So generally speaking, a lower P/E ratio is better.

There are 2 issues with the P/E ratio as a measurement. First, what if earnings is negative or very small. It makes it hard to compare to companies with positive P/E ratios or comparing P/Es of 15 vs 500. Also, having a negative P/E ratio does not mean the firm is worthless either. Sometimes when earnings are negative, it will just be reported as a P/E of 0.

The second issue is concerning the capital structure of the stock/company in question. Take a look at 2 mythical companies below. Assuming everything is exactly the same except how they were funded, one with more debt and one with more equity. You can see the resulting difference in net income.

Assuming both firms are in a very stable industry with no chance of the business dying off and having the same amount of shares outstanding, if you used the P/E ratio to compare these two firms, you would have 2 very different results.

One method of working around this is a ratio called EV/EBITDA. EV stands for enterprise value. The math for EV is market cap of the firm + debt + minority interest + preferred shares - cash and cash equivalents. Or in other words, it is what the company is really worth. (Note how the price of the company should also be the measure of the company's worth)

Now EBITDA stands for Earnings Before, Interest, Taxes, Depreciation, and Amortization. In other words, the money the company makes before you factor in how the company is structured financially, with debt/equity.

What it boils down to is that you are using EV to replace Price and EBITDA to replace earnings. This will give you a measure of the value of the stock/company regardless of if it relies heavily on debt or not. Do keep in mind, firms that rely heavily on debt, have the benefit of reducing taxes for the firm, but may also be a sign of serious financial issues if they have trouble paying off their debt.

This proxy will allow you to compare the firms if capital structure is not a major consideration. In addition, it allows you to see the true operating performance of the company, as generally speaking, one company with plenty of debt can pay it down, and one company with plenty of debt, can borrow money and increase debt in their structure.