One of the most common measures of valuation in the market is the Price-to-Earnings (P/E) ratio.
This ratio tells us that a stock is cheap when its P/E is low relative to the market or expensive if the P/E is higher than average.
But the problem with using P/E ratio is that it does not take into account the debt and cash of the company, which may distort the value of the business.
For example, Rockwell Land and Shang Properties have similar P/E ratios of 5.4x, but they differ significantly in their capital structure.
Rockwell has a higher debt-to-equity ratio of 1.2 times as compared to Shang, which has a conservative low debt-to-equity ratio of only 0.2 times.
The different leveraging strategies taken by both companies to finance its future growth are not reflected in their P/E ratios.
When we use P/E ratio, the focus of the pricing is on the market capitalization and net income.
The market capitalization is computed by multiplying the shares outstanding of the company by the market price of the stock, while the net income is the reported earnings exclusive of all expenses.
To have a better comparison to evaluate which stock is a cheaper deal, an alternative way is to value the company as a whole business.
Imagine if you were to buy a company, you would not only acquire ownership but also absorb its existing debts too upon takeover and if there is any cash left, you can either use it to repay the debt or simply pocket it.
So, in order to find the “true” worth of the company, we can simply add the total debt to its equity and deduct the cash. The resulting figure is what we call the Enterprise Value (EV).
Similar to P/E ratios, we can also divide the EV with its corresponding earnings to get the relative metric for comparison.
Since the EV includes debt, the earnings to be used shall also include interest expenses, or the operating profit or Ebit for short, which stands for Earnings Before Interest and Taxes.
The EV/Ebit ratio is supposed to make up for other areas in pricing stocks where the P/E ratio falls short.
The great Warren Buffet once said that when he invested in companies, he generally looked for a decent business with 7 times EV/Ebit multiple that grew at least 8 percent per year.
Going back to the above example, Rockwell Land and Shang Properties may have similar P/E ratios but when it comes to EV/Ebit multiples, Rockwell comes out five times more expensive than Shang.
Rockwell has 26 times EV/Ebit while Shang has only 5 times after debts and cash are included in the computation.
While it may be true that the lower the EV/Ebit of a company, the more it is thought to be financially stable, it does not necessarily follow that financially leveraged companies have higher EV/Ebit multiples.
For example, San Miguel Corp., which has a similar P/E ratio with Puregold at 20 times, has higher debt-to-equity ratio of 2.8 times against 0.50 times of the latter.
But San Miguel, which has 10.2 times EV/Ebit multiple, is 60 percent cheaper than Puregold’s 24 times.
Why is this so? Remember that taking higher risk can lead to greater probability of higher returns.
When companies borrow capital, they can expand their asset base and generate larger profits.
The greater the operating profits from the investments, the lower the EV/Ebit ratio. But using leverage may also result in lower profits or even losses.
A highly leveraged company may have high P/E ratio because of lower net income caused by high interest expenses.
But if its investments generate higher operating profits that lead to lower EV/Ebit ratio, then it is not expensive.
In the same token, a debt-free company with low P/E may not really be a bargain if it has high EV/Ebit ratio, because its operating profits are not growing enough due to lack of new investments.
If you want to compare stocks on the same playing field by evaluating a company’s profitability regardless of its capital structure, the EV/Ebit multiple can be a good substitute to P/E ratio to find value stocks.