Why P/E Ratio is a Trap?

There are two companies – AA and BB.

Assume that both the companies are identical in all ways (Business, Revenue, clients, competitors).

We also assume the following –

  • Current Market Price of AA and BB = 40 Rs.

  • Number Outstanding stocks for both stocks = 100

In this case valuations of both the companies should be same.

Introducing slight complication here! Though all parameters are equal, we make an only change with respect the depreciation policies used by each company.

AA follows Straight Line Depreciation Policy and BB follows Accelerated depreciation policy. Straight line charges equal depreciation over the useful life. Accelerated Deprecation policy charges higher depreciation in initial years and lower depreciation in final years. The successful management of a company demands a correct approach towards the problem of depreciation.

Let us see what happens to their valuations:

As noted above, the PE ratio of AA is 22.9x while PE ratio of BB is 38.1x.

So which one will you buy? Definitely A.

Now our very assumption that these two companies are identical twins and should command same valuations is challenged because we used PE Ratio.

This is one of the biggest limitations of PE ratio.

This huge valuation problem is solved by EV/ EBITDA Ratio.

ENTERPRISE VALUE (EV) = Market Cap + Debt – Cash & Cash

EV is used as a better alternative to market capitalization. Theoretically, the calculated enterprise value can be considered as the price or value at which the company is bought or acquired by an investor. Ex- If Today TCS buys persistent in $100 bn then this would be its Enterprise value.

EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization

Let us now look at the table below -

Enterprise value of AA and BB are same. Though PAT for AA and BB was different, we note that EBITDA is not affected by the depreciation policy used. AA and BB have the same EBITDA of 400.

Calculating EV to EBITDA (AA & BB) 4400 / 400 = 11.0x

So, EV/EBITDA of both AA and BB is same at 11.0x and is in consonance with our core assumption that both companies are same. Therefore it doesn’t matter which company you invest into!

The division of EV by EBITDA gives a good measure of value. It estimates the number of years in which the business will repay its acquisition cost to the buyer through its earnings. For example, if one is interested in buying a firm at an EV of Rs 1,000 crore and its annual earning (EBITDA) is Rs 200 crore, the firm will repay its entire acquisition cost to the buyer in cash in just five years.

Generally, the lower the ratio, the better it is. The ratio helps determine the true earning potential of the business.

One more disadvantage of P/E Ratio: PE ratio is inversely proportional to the Earnings Per Share of the company. If there is a buyback, then the total number of shares outstanding reduces, thereby increasing the EPS of the company (without any changes in fundamentals of the company). This increased EPS lowers the PE ratio of the company. Though most companies buyback shares as per the Share Buyback Agreement, however, one should be mindful that the management can adopt such measure to increase EPS without any positive change in company’s fundamentals.

The only drawback of EV/EBITDA is It cannot be used when the current cash flow is negative.

It is important for small investors to understand the basics of such ratios as these can help them analyse the stocks more effectively. To contact the Author on LinkedIn click here For more useful articles: click here For online video lectures for learning Stock Analysis click here If you want us to design your Stock Portfolio click here

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