*Repost* Why The P/E Ratio Is Useless – And How To Calculate EV

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Earlier this week I posted a 12:49 video case study part 1 on Armanino Foods (AMNF) showing how I analyzed the company on a preliminary basis.  What everything meant.  And why each metric is important.

But I didn’t explain how to calculate EV/EBIT and EV/FCF when I talked about them in the video.  In this post I will.  But before I do that I need to show you why the P/E ratio is useless.  And why you should never rely on it as a long-term value investor.

Why I Hate The P/E Ratio

Last week I got a couple questions from a Press On Research subscriber.  The first question was why I didn’t use P/E when detailing the company I recommended. And the second question was how the company could be cheap when it had a P/E of 17.

I won’t detail what I said to the subscriber because I would have to reveal the company and industry it’s in.  But below I will show you the reasons I hate the P/E.  And why I never use it in my analysis.

P/E Is Turrible

The P/E ratio is two components.  P is price per share and E is earnings per share.

You find price per share by dividing the total market cap of the company by the amount of shares the company has.  And earnings per share is net income divided by the total number of shares a company has.

You then divide the price per share by the company’s earnings per share over the last year to find its P/E.  The example below is from Investopedia.com.

For example, if a company is currently trading at $43 a share and earnings over the last 12 months were $1.95 per share, the P/E ratio for the stock would be 22.05 ($43/$1.95).

Don’t worry you won’t have to calculate this.  All financial sites report P/E ratio for you when you look up the stock ticker.  And many investors – including me when I started investing – thought this was the best relative valuation to look at.

But it isn’t…

The P/E ratio is a misleading and dangerous metric.  And it’s one of the worst metrics to rely on as a long-term value investor.

Why?

Because of debt, cash, and manipulation…

Why P/E Ratio Is Useless

Below are examples I made up to illustrate why P/E is a useless metric.

On a P/E basis company one looks better right?  But what happens when you add in important things like cash and debt to the equation?

Which company would you rather buy now?  The company with a lot of net debt or the company with a lot of net cash?

But this isn’t the only reason P/E is misleading…

Earnings Are Easy To Manipulate

The E in the P/E equation is earnings like I showed above.  Another reason I don’t like P/E is because earnings are easier to manipulate than EBIT, FCF, and owner’s earnings.

One example is a company “smooths” earnings over time to make it look like the company is earning consistent good profits.  Rather than lumpy profits that fluctuate a lot.

This is a huge discussion that goes beyond the scope of this post.  But if you want to learn how companies manipulate earnings read this from Investopedia.  And read the great book Financial Shenanigans.

But these aren’t the only downfalls of using P/E…

The earnings part of P/E is after all costs, taxes, and expenditures.  EBIT, FCF, and OE are all after costs and expenditures but before taxes.  Another way companies can manipulate earnings is with the tax rate the company states it has to pay.

If you work hard enough you can make the tax rate whatever you want it to be.  Just ask General Electric (GE).

And because EBIT, FCF, and OE is profit a company makes from its operations.  These metrics show a much truer picture of how profitable a company’s operations are.  And if a company is operating in a healthy way.

So P/E is not only a terrible metric to rely on with any company that has debt and cash. Which is of course all companies.  But it’s also easier to manipulate than other metrics.  And it doesn’t show how profitable and healthy a company’s operations are.

This is why I use enterprise value (EV) instead…

So How Do You Calculate Enterprise Value?

I calculate enterprise value as…

• EV = market cap + preferred shares value (if any) + debt – cash and cash equivalents.

My calculation of EV is the same as the picture above but in easier to understand terms.

Why is EV better than P/E?

Which Metric Is Better?

I love enterprise value when evaluating businesses.  It shows the true picture of what a company should be valued at if you were going to buy the whole business.

This is how I evaluate all businesses for investment.  If I was able to buy the whole company, what price should I pay for it in total?  And per share?  EV helps us find this number.  And when combined with EBIT, FCF, or OE it’s also a better relative valuation to use than P/E.

So instead of using the flawed P/E you should use EV/EBIT, EV/FCF, or EV/OE to find what a company is worth on a relative basis.

EV replaces P in the P/E equation.  And operating margin (EBIT), free cash flow (FCF), or Owner’s Earnings (OE) takes the place of E in the equation.

EBIT, FCF, and OE can all replace earnings in the P/E equation.  And all three tell you different things when compared against EV.

EV/EBIT shows you what the company is worth compared to its operating profits.  EV/FCF shows you what the company is worth compared to the free cash it generates from operations.  And EV/OE shows you what the company is worth compared to the value you could take out of the company if you owned it.

Let’s keep things simple and only worry about EV/EBIT and EV/FCF today though.  I will explain how to calculate owner’s earnings when we get to that point in the case study.

Another name for EBIT is operating margin.  But it’s also called operating income or operating earnings.  You can find this by going to a company’s income statement under the financials tab on Morningstar.  FCF is on the cash flow page under the financials tab on Morningstar.

I use EBIT and FCF because they are harder to manipulate.  And show what a company earns from its operations in the case of EBIT.  Or in the case of FCF – show how much cash the company has left after paying for things to upgrade and improve the business.

So what does this all mean when continuing the example above?

Why I Love EV/EBIT and EV/FCF

If we were to continue the above example we would just need the company’s market cap.

• Company 1 EV = 100 + 40 – 0 = 140
• Company 2 EV = 100 + 0 – 40 = 60

Which Company Would You Rather Own?

Now that we have found EV for the made up businesses above.  Let’s take this further and see which company is the better buy now…  At least on a relative valuation basis.

EV above is the estimated price you would have to pay to own the whole company.

Now that we’ve found EV for both businesses we can bring in EBIT and FCF to find EV/EBIT and EV/FCF.

Now that we’ve replaced the terrible P/E ratio with EV/EBIT and EV/FCF.  We’ve got a better look at what the company truly is worth on a relative and intrinsic basis.

This is how business owners evaluate businesses.   And we as long-term value investors should consider ourselves business owners.

Which company looks like the better buy now?  And what is your favorite relative valuation metric? Let me know in the comments below.

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