P/E multiplier: good or bad?
The P/E multiplier (price/profit) is one of the most popular, however, it may be incorrect to use it to compare companies in some cases.
Price-to-Earning (P/E) is an indicator equal to the ratio of the market value of a stock to the annual profit received per share. This is the most popular and well-known multiplier among investors, which shows how many years investments in a particular stock will pay off. An inverted E/P indicator is often used, which denotes theoretical profitability.
P/E (Price/Earnings) is calculated as the amount of capitalization to the annual profit of the company.
Due to differences in Central Bank rates and inflation rates, investors expect different returns in different countries.
Another pitfall is that the company's profits are changing.
For a stagnating company whose performance increases by only a few percent per year, the multiplier value will be close to the real payback
For a growth company, P/E doesn't work. If a company has P/E = 100 and, for example, doubles its profit annually, then this company will pay off not in 100 years, but in 6.
The P/E comparison is only suitable for stagnating companies within the same country. For growth companies, the multiplier does not work.
Who needs a P/E multiplier and why?
The P/E ratio shows the number of years for which your investments in the company's shares will pay off. The multiplier also helps to look for undervalued assets relative to their profits.
There are three types of P/E, depending on the data used for the calculation:
- Annual. The current capitalization of the company is divided by the net profit for the previous calendar year.
- Sliding. Calculated for the last four quarters. It is effective when the results of last year are not relevant.
- Forward. The future profit of the company for the current calendar year is taken into account for the calculation. Forecasts of future profits are made by analysts who may not always be right.
It is believed that small values of the indicator indicate the cheapness of stocks, and large ones indicate the high cost. However, not everything is so simple.
It is always important for investors to understand what underlies the calculation of the multiplier.
For example, one company has P/E = 2, and the second has P/E = 7. Is the choice obvious?
Not quite. We need to look at other indicators of companies.
The second company could have a one-time revaluation, as a result of which the profit decreased significantly. Therefore, the P/E coefficient has decreased significantly at the moment.
P/E may evaluate an asset biased. A high P/E value is not always a bad thing. Perhaps the market has inflated expectations from the company. A low valuation indicates a quick payback, and also shows investors' doubts about the company's prospects.
P/E is a simple indicator that helps to conduct an express analysis of the company. However, you should not use it only to select papers in your portfolio.
Why will the P/E multiplier prevent you from earning?
Different "gurus" on the Internet write about the miraculous properties of the P/E multiplier every day. At the same time, few of them pay attention to the insidiousness of this indicator.
But not everything is so simple.
Many novice investors, after reading the books of Benjamin Graham or Warren Buffett, begin to blindly believe in this multiplier and decide to buy shares only on its basis.
It turns out that at the moment of the most "delicious" prices on the market, the P/E indicator spoke about the revaluation of the companies included in the index. Investors focusing only on this indicator alone were forced to buy shares that had already risen in price considerably.
To understand how overvalued or undervalued the stock market is, the P/E ratio is often used.
However, this evaluation method is far from perfect. The effect of a one-time drop in profits due to emergencies (coronavirus, for example) overestimates the value of P /E, which is not necessarily and not in all cases indicates a reassessment of fundamentally strong companies.
At the moment, the aggregate valuation of P/E companies included in the S&P 500 index is 39.81x. It seems that this is an exorbitant amount.
The Shiller P/E ratio, which eliminates fluctuations caused by a one-time change in profits during business cycles, is 35.7x. This is below the record score of 44x on the dotcom crash of 2000.
In addition to P/E, when evaluating any company (and the index is one large holding out of many companies), it is also necessary to take into account the rate of profit growth. To do this, another multiplier is used - PEG.
A company valued at 20 P/E, whose profit is growing by 5% per year, is not an interesting investment, since mathematically it loses to a company with a P/E of 40, but with a profit growth rate of 15% per year.
In addition, to answer the question of how overvalued / undervalued the market is, you need to look not at past historical estimates and think about the bubble, but at the profitability of alternative investments in the present and in the future (for example, bonds).
Read more: P/E Ratio: what it is needed for and how it is calculated
Looking for undervalued stocks with a P/S multiplier
Price-to-Sales (P/S) shows the ratio of a company's value to its annual revenue. For example: a company is worth $1,000,000, and its revenue is $500,000 per year.
P/S = 1 000 000 / 500 000 = 2.
The lower the indicator, the faster the company will recoup its value from revenue.
High P/S - stocks are expensive. Low means that stocks are cheap (undervalued). And this is exactly what the investor is interested in!
On average, the optimal market is considered to be P/S no more than 2. However, it may differ for each industry. How to understand which indicator is the norm for your sector? You need to take several companies and compare their multipliers with each other.
Why is it advantageous to use P/S rather than P/E?
P/E = the ratio of the company's value to profit. But the profit may be negative, and then the P/E multiplier is not applicable.
But the revenue is always positive. According to the P/S parameter, we can safely evaluate any company.
Revenue doesn't fluctuate as much as profit. Therefore, P/S is often more objective.
Friends, when analyzing a company, we do not rely only on multipliers! We also look at other indicators: debt burden, cash flows, the situation in business as a whole.
P/S is just one of the parameters that can be used to evaluate stocks! Although very convenient.
Enterprise Value
Enterprise Value (EV) is a measure of the total value of a company. EV is often used as a more comprehensive alternative to market capitalization.
Unlike capitalization, which shows us only the amount in which market participants value the company, Enterprise Value takes into account the company's debts and cash
Formula:
EV = MC + Total Debt - C
- MC – Market capitalization. It is calculated as the product of the price of one share by the total number of shares.
- Total Debt is the sum of the company's long-term and short-term loans.
- C – Cash and cash equivalents.
How to understand what Enterprise Value is?
Imagine that company A wants to absorb company B. The buyer company will pay a certain price (capitalization) under the transaction, but at the same time company A will receive all the debts and money of company B.
If there are more debts than cash and equivalents (net debt is positive):
- Part of the debt can be repaid at the expense of the funds of the acquired company, but part will still remain and company A will be forced to repay it in the future. EV = MC + the remaining part of the debt.
If there are less debts than cash and equivalents (net debt is negative):
- The entire debt can be repaid at the expense of cash, and the remainder can be used for development, asset purchase, investment, payment of divs, etc. Everything that remains after debt repayment will reduce capitalization. EV = MC - the remainder of the funds after repayment of the entire debt.
EV is used to calculate multipliers. EV/EBITDA, EV/EBIT, EV/Sales(Revenue) and EV/FCF. They are advanced analogues of P/E, P/S and P/FCF, respectively.
Read more: Markowitz theory. Ways to select an investment portfolio
The value of the EV/EBITDA multiplier in the analysis
The EV/EBITDA multiplier, popular among investors and analysts, has its advantages and disadvantages, just like any other multiplier.
In its numerator is the most reliable assessment of the issuer - EV. But since the denominator indicates an ambiguous EBITDA profit accounting model, the multiplier may have a large error.
Advantages of EV/EBITDA
- When calculating EBITDA, the interest rate on loans is ignored, and taxes are not taken into account, since they can vary greatly depending on income and losses in previous periods.
- EBITDA makes it easier to compare different companies with different capital structures, tax rates and depreciation policies.
EV/EBITDA disadvantages
- EV/EBITDA is not applicable for financial sector companies, since their concept of debt in the reporting has a completely different meaning.
- Ambiguity - negative EV/EBITDA will not answer the question of what is happening in the company.
- Both the numerator (when there is more cash in the company than its market cap) and the denominator (when there is a loss) in the calculation formula may be negative. Moreover, they can both be negative, and then the result will be positive.
If you see a negative P/E, you know that the company has a loss. If you see a negative EV/EBITDA, you don't know anything.
EV/EBITDA is not applicable for evaluating growing companies: a loss or low profit distorts the perception of the real value of the company.
Buffett - one of the critics of EBITDA, says that EBITDA does not take into account depreciation, and this is wrong.
Depreciation and reserves for modernization are non-monetary items, but they cannot be postponed for later, or spent on dividends: equipment inevitably wears out, and funds will be needed for replacement or modernization.
EBITDA is not equal to Cash Flow.
EBITDA ignores taxes and interest on loans, although these are real monetary costs - how can they not be taken into account in the analysis?
EBITDA does not take into account capital expenditures - the current, important cash costs of each company.
EBITDA ignores many aspects of the business, ignores cash costs and actually overstates cash flow.
Using only EBITDA, in isolation from the real cash flow, is fraught with obtaining false information.
Read more: What is the Risk and Return Concept
Key multipliers to pay attention to when evaluating a REIT
- Price/FFO: Essentially, price to FFO means how many dollars you pay for $1 of cash flow from which the REIT pays dividends. You can use a modified Price /adjusted FFO indicator: this is a more accurate "cartoon", since it gives an idea of the true ability of the REIT to pay dividends.
- Price to Net Asset Value (P/NAV): The net asset value (NAV) is the difference between total assets and total liabilities. In other words, it is the market value of the real estate owned by the REIT. The ratio of price to net asset value (P/NAV) > 1 means the REIT is trading at a premium to its NAV, and vice versa.
- Net debt / FFO is one of the indicators of the debt burden. Since REITs traditionally have a high level of leverage, it makes sense to track these coefficients, correlating their values with the stage of the market cycle.
- Interest Coverage Ratio. A coefficient that determines how easily the fund can pay interest expenses on outstanding debt. Calculated by dividing net property income (NPI) by interest expense. The multiplier value of more than 5 is ideal.
- Return on assets (ROA) vs average interest rate on loans (average interest rate on loans). Since REITs develop at the expense of debt, it is important that the profitability (%) of its assets exceeds the cost of raising capital (%). The difference between them is the carry that the REIT generates to its shareholders.
How to evaluate the effectiveness of a company using multipliers?
To determine how effectively a company operates, it is enough to look at its profitability indicators. These indicators come in different types, but we will look at the most basic ones.
- ROS (Return On Sales). This indicator is calculated as the profit/revenue of the company. It shows how much profit each dollar of revenue brings. That is, if ROS is 20%, it means that for each dollar of revenue received, the company has 20 kopecks of profit left.
- ROA (Return On Assets). It is calculated as the profit / assets of the company. It shows how effectively all the assets of the company work.
- ROE (Return On Equity). It is calculated as the profit / equity of the company. It shows how effectively profit is generated at the expense of the company's own funds, excluding liabilities.
But a high ROE does not necessarily mean effective management. If a company uses a large amount of borrowed funds, then its ROE may even be very high, but the debt burden is a direct threat to the financial stability of the company.
This is not a complete list of all profitability indicators, but the calculation logic is about the same for everyone: the financial result is divided by the outgoing indicator.
Usually, the higher the indicator, the better, but, as we have already said, there are exceptions.
It is also worth noting that only companies from the same industry should compare these indicators.
For example, in retail, the net profitability indicator is always very low (about 2%), while in the gold mining sector, it may well be at the level of 30-50%. Therefore, comparing companies in these industries by profitability is not the best idea. The same applies to the other multipliers.
Read more: What is the essence of the Sharpe Ratio and what is it for?
How not to buy a potential bankrupt?
Before buying shares of a company, always take into account the financial condition of the issuer's business. This is especially true for dividend companies, because a large debt burden complicates the payment of dividends.
The main multipliers that you need to pay attention to:
- D/E (Debt-to-Equity) - the ratio of the company's debt to its capital. The indicator shows how much borrowed funds account for each dollar of equity. An acceptable indicator is at the level of up to 1.5x.
- Current ratio (Current liquidity ratio) - calculated as current assets / current loans. Shows the company's ability to pay for short-term liabilities (up to 1 year) at the expense of current assets.
- Net debt / EBITDA is the ratio of net debt to EBITDA of the company (earnings before interest, taxes and depreciation). The multiplier conditionally shows how many years a business needs to pay off its debts, taking into account current profitability. The relatively safe level is at levels below 2x, if the coefficient exceeds 3x - this already indicates the creditworthiness of the issuer.
Multipliers are just an addition to the financial analysis of the company. For a more detailed consideration, it is worth analyzing the reporting and tracking other debt parameters and external factors.
Return on assets (ROA) and sales (ROS)
Profitability is an indicator of the economic efficiency of the company. The growing importance from year to year indicates an improvement in the efficiency of management.
One of the main advantages of comparing corporations by profitability is the ability to almost completely ignore their differences in size.
ROA (return on assets) is the ratio of net profit to the average value of the company's assets for the period. It shows how effectively the company uses its assets (buildings, machines, intellectual property, etc.).
Assets are always equal to liabilities, so in fact ROA shows the return on all sources of capital (own and borrowed).
If ROA = 10%, then for every dollar of asset value there is 10 cents of profit.
The return on assets should be compared with the industry average: capital-intensive companies (oil, utilities, financial, etc.) will have a much lower value than technological ones.
It is also possible to separately calculate the profitability of non-current assets (buildings, machines, machines, etc.) and current assets (raw materials, finished products, etc.)
ROS (return on sales) is the ratio of operating profit to the company's revenue. Shows the effectiveness of the company's operational (core) activities.
Operating profit = revenue - fixed costs - variable costs. If ROS = 10%, then for every dollar of revenue there is 10 cents of operating profit.
It is worth using ROS to compare companies with the same business models in the same sector.
Read more: Tobin's Q Ratio: calculation, application and features
Return on Equity (ROE)
ROE (return on equity) is the ratio of net profit to equity of the company. It shows the efficiency of the shareholders' funds. It is compared, as a rule, with competitors.
If ROE = 10%, then for every dollar of equity there is 10 cents of profit.
The ROE can be correlated with the market rate of return to find out if the existence of the company makes any sense.
If ROE = 3%, and the bank deposit rate = 5%, then doing business is unprofitable. It is easier to sell off all assets, pay off debts and invest in a bank.
The pitfall
In fact, investors could choose companies with the highest ROE. However, it's not that simple.
High ROE does not necessarily mean efficient use of equity. The use of a large amount of borrowed funds can also lead to a high ROE. However, a high debt burden is a direct threat to the financial stability of the company, and hence its investment attractiveness.
It is especially important to understand the current market conditions and the level of credit availability when assessing the return on equity.
For example, the company Service Corporation International (#SCI) ROE = 23%. This is higher than the industry average (6.5%). However, the debt-to-equity ratio (debt/equity ratio) = 2.01, which is also much higher than the average. As a result, the return on all assets (ROA) of the company is only 3.4%.
How to get the maximum profitability in the market? Alpha and beta coefficients
The higher the risk, the higher the return. Everyone knows that. However, is it possible to build a portfolio that will have minimal risk and maximum profitability? And the answer is: yes, you can. Alpha and beta coefficients will help us in this. Let's figure out what it is and what they are eaten with
Beta coefficient
The profitability of a broad market is usually measured by the profitability of the index. In the US, the main index is the S&P500. It is believed that all stocks always follow the index in the long run. However, in the short term, securities may deviate from the index, sometimes ahead of it, then lagging behind.
Taking into account these deviations, W. Sharp calculated the beta coefficient. Simply put, the beta coefficient shows how much the paper deviates from the index.
If beta is equal to 1, then the stock moves along with the index.
If the beta is less than 1, then the paper reacts poorly to fluctuations in the market, which means it is less risky.
If more than 1, then this indicates an increased risk. For example, if the beta coefficient of a stock is 2, then when the index grows by 1%, the paper grows by 2%, the same goes in the opposite direction.
Negative beta is also rare. This means that when the index grows, the asset will fall, and when it falls, it will grow.
Alpha coefficient
Everyone knows that high profitability equals high risk. However, many well-known investors often overtook the market. Does this mean that they were simply taking on an increased risk? Or does it speak about the skill of the manager?
To find out, economist Michael Jensen calculated the alpha coefficient. Roughly speaking, the alpha coefficient shows the skill of the manager.
With passive investing, the alpha is 0, since no action is taken. If alpha is positive, then the manager's portfolio shows profitability better than the market, if negative - worse.
Today, alpha is calculated not only for managers, but also for stocks. For example, if alpha is equal to 1, then the stock is consistently ahead of the market by 1%.
Thus, in order to obtain maximum profitability with minimal risk, the alpha of the portfolio should have the highest value, and the beta should have the lowest. The coefficients can be calculated independently, or you can resort to specialized services.
Unusual multipliers that you didn't know about
Few people know, but in addition to the classic multipliers (P/E, P/S, P/B) there are also specific ones. They have such a name because they are used only for specific industries.
They can be viewed either on paid services, or in the release of the company itself, or they can be calculated independently. Let's take a closer look at what they are.
As we have already said, each industry has its own special multipliers.
Thus, in the financial sector, the indicators of net interest margin or the ratio of loans to deposits are specific. To be clear: the net interest margin is the difference between the rate at which the bank issues loans and the interest at which it borrows itself. The higher the interest margin, the more efficient the bank is.
In retail, these are revenue indicators per square meter or LFL (like-for-like) sales. They do not take into account the opening of new stores, so they can be used to assess how effectively the existing ones work.
For Internet companies, the number of visits to a website or application, the number of clicks per day, etc. can be applied.
In telecommunications, the indicator of annual revenue per subscriber is often used.
In the oil and gas sector, indicators such as EV/Production (company value/daily production in barrels) or EV/Reserves (company value/size of reserves) can be used.
The use of specific multipliers helps to better understand the company's business and take into account the specifics of its industry.
However, some multipliers are not enough for a full-fledged analysis of the company, so it is important to pay attention to other business indicators.
Other strange multipliers. What are Forward and LTM?
Studying the multipliers of companies, you may notice that some of them are marked with strange designations - LTM and Forward.
What does it mean?
The abbreviation LTM stands for Last Twelve Months. Such multipliers are calculated based on the indicators for the last 12 months.
The Forward designation means that the multiplier is calculated based on forecasts for the current or next year. Such multipliers are called forward multipliers.
How to calculate LTM and Forward?
For example, take the P/E multiplier. As P, it always takes the current capitalization of the company, and the value of E (net profit) depends on the calculation method.
- The standard method. The amount of E is taken as the amount of net profit received by the company for the financial year. For example, the company's capitalization is $ 100 billion, and its net profit for 2020 was $ 10 billion. Then P/E is equal to: 100 billion / 10 billion = 10.
- LTM method. To calculate E, we will need data on the company's net profit for the last 12 months (that is, for 4 quarters). It is now the 3rd quarter of 2021. Let's say we have reports for the 1st and 2nd quarters of this year. Then, to calculate E, we will add up the net profit for 1-2 quarters of 2021 and 3-4 quarters of 2020. Substituting the obtained value of E into the formula P/E, we get P/E LTM.
- Forward method. As an example, we take the forecast for the company's net profit. For example, analysts' forecast says that our company's net profit for the year will be $ 20 billion. Then its forward P/E will be equal to: 100 billion / 20 billion = 5
Other multipliers can also be calculated using LTM and Forward methods.
EPS indicator: How much money will owning a stock give you?
We continue to study the topic of fundamental analysis. And let's talk about the indicators again.
Our topic today is EPS, stands for "Earnings Per Share", or "Earnings per Share". EPS = net profit / number of shares.
Diluted, or Diluted EPS is singled out separately. To calculate this indicator, the weighted average number of shares for the analyzed period is taken. This makes it more accurate.
Read more: EPS: about Earnings per Share with examples in simple words
How does EPS work? Let 's take an example
The company earned $100,000 in profit for the year. She has 100,000 shares issued. EPS = $1. Is it a lot or a little? How to understand?
To begin with, let's calculate how much it is as a percentage of the value of the stock. If the stock is worth $10, then $1 is 10%. Your return on this stock will be 10% per year. We compare this indicator with the indicators of similar companies from the same industry and choose the one that has more. The higher the indicator, the more money the shareholders of this company will earn.
If a company conducts an additional placement of shares or SPO, its EPS decreases as the number of shares in circulation increases. Accordingly, shareholders begin to earn less, the price of securities falls. If the company conducts a share buyback, then EPS, on the contrary, grows. This means that the stock price will also grow.
You can interpret EPS by analyzing its growth over the past years.
It happens that EPS grows faster or slower than the company's profit. This is due to a decrease/increase in the number of shares in circulation. Often, the growth of EPS says even more than the volume of profit itself.