Price Earnings Valuation – Why it’s not good to use as isolated valuation approach
Price earnings ratio (P/E) is a commonly used valuation metric. It is very simple to calculate and easily understood. Therefore, it is helpful to identify potential bargains, but further analysis is required.
How to calculate P/E?
Companies share price is $ 100 and the company earns $ 20 per share (EPS = earnings per share).
P/E = Price/Earning = 100/20 = 5.
A P/E of 5 is often considered very low and can be interpreted that the company is cheaply valued or undervalued. Whereas for example a P/E of 40 is considered high.
In below example I will show you why this is not always the case and how P/E can be manipulated. We have two companies:
Company X and Y with the same revenue, Enterprise Value (EV) and EBIT but different capital structure.
Company X has no debt and Company Y operates with 50% equity and 50% debt an pays 8% interests on its debt.
Interest expenses of Company Y lowers their profit but also their tax liabilities.
As you can see company Y looks much cheaper on an isolated P/E valuation with a PE of 10.42 vs. 12.5 for company X. Why is that? The simple answer is that P/E falls with an increase in financial leverage.
P/E is a weak technique of comparing company valuations as the same company can generate quite different P/E multiples solely because of variations in its debt level.
Even though both companies deliver the same earnings and company Y looks much cheaper on a P/E multiple, company X is the more attractive investment as it’s less risky due to its lower leverage.