Price-to-earnings ratio is one of a number of measurements that investors sometimes look at in evaluating stocks. If a stock's P/E ratio is relatively low compared to similar stocks, that can be a sign that it's undervalued, meaning that it's potentially a good place to invest your money. It's always worth looking at factors that may be causing the P/E ratio to appear low, however, as it may be a sign that earnings are likely to fall in the future.
A low P/E ratio isn't always good or always bad, but it can be a sign that a stock is a relative bargain compared to competing companies. That's because you can theoretically buy a share in the company's earnings for less than it would cost to buy into the same earnings from another firm.
The Price-to-Earnings Ratio
The price-to-earnings, or P/E, ratio is computed by dividing a stock's share price by its earnings per share. You can look up these numbers on a brokerage or financial news site and compute it yourself, and many such sites also list the P/E ratio along with the other numbers.
Investors usually compare P/E ratios of stocks that are in some way similar, such as businesses in the same industry and at the same point in their life cycles. For instance, you might compare the P/E ratios of two tech startups to determine if one appears to be a better bargain than the other. You can usually find published numbers for average P/E ratio ranges in various industries.
Remember that if you're monitoring how one stock's P/E ratio has evolved over time, you'll need to make sure to adjust the stock price for stock splits, which change the price of a share but also adjust how much of the company a share confers.
Comparing P/E Ratios
Since P/E ratios can vary between industries and based on how established a company is, not all P/E ratio comparisons are equally useful. In particular, startups often have high P/E ratios relative to more established companies because investors are factoring in the likelihood of high future earnings, not just the earnings that have been reported to date.
Note that a low P/E ratio doesn't always mean that a stock is undervalued, since it may be that investors are factoring in warning signs that indicate lower earnings or other troubles in the future. Do your research before you buy and sell stocks based on a single factor like P/E ratio alone. A low P/E ratio meaning a bargain is very different from a low P/E ratio meaning investors see trouble ahead for the business.
The MVIC/EBITDA Ratio
A similar ratio often used for evaluating companies is the market value to earnings before interest, taxes, depreciation and amortization ratio. Market value, or market value of invested capital, is the total amount of all investment in the company, including debt, so it's a slightly different number than simply the price of the company's stock.
EBITDA, as the name suggests, is the company's profit or loss before certain types of costs are considered. Specifically, it excludes costs for interest on borrowed money, taxes paid to the government and depreciation and amortization of assets. It's often seen as a good estimate of the company's return on its basic operations.
To find this ratio, simply divide the market value of all debt and stock by EBITDA, a number that's often shared by the company. Advantages of using this ratio rather than the traditional P/E ratio include that it focuses on a company's core operations and that it still makes sense for companies that are experiencing net losses, rather than positive earnings, if they have positive EBITDA. As with the P/E ratio, it can be especially useful to compare MVIC/EBITDA ratios between companies in the same sector to see which might have a good hidden value.
Understanding Enterprise Value
Enterprise value is the total value of a company's stock, including all types of shares, and the market value of its outstanding debt, usually subtracting any cash that it has on hand since this isn't part of the core business. It's essentially the value that someone would have to pay to own the company in full, since a buyer would need to pay all the outstanding debt and buy all the stock in order to take ownership of the business.
It's different from the book value of the company, which is the sum of the value of all the assets in its accounting books minus its liabilities, since the market value of the company can be different than its nominal accounting value, especially since buyers will consider the company's future direction.
Enterprise value is also often more than the company's market capitalization, which is the sum of the value of all of its outstanding shares of stock. Enterprise value includes market cap plus the value of all the company's outstanding debt, so it will be greater if the company has debt.
EV to Capital Employed
Yet another useful ratio in business evaluation is the ratio of enterprise value to capital employed in a particular business. Capital employed is the total investment value used by the company. You can find this value by subtracting the company's liabilities from its total assets. In some cases, only current liabilities, usually meaning those that must be paid within a year, are subtracted from the company's total assets.
The ratio of enterprise value to capital employed essentially measures how much value was generated by the company's assets. In theory, a company with a higher such ratio is better at turning its assets into value for the company's owners.
Free Cash Flow
Investors also sometimes look at the ratios of enterprise value and market capitalization to another measurement called free cash flow. Free cash flow is defined as the net cash generated from operations, known as operating cash flow, minus what the company invests in capital expenditures such as buying real estate and durable equipment like manufacturing hardware or computers.
It's often studied to understand whether a company will have sufficient cash on hand to pay its expenses, such as salaries and rent. Even if a company's assets exceed its liabilities and it is growing in value and making a profit, it can still end up in a cash crunch and have to sell assets or take out a loan if it doesn't have cash on hand to make ends meet.
Note that in finance, the term cash or cash and equivalents is used to represent any liquid holdings, including money in a bank or securities like Treasury bills that can quickly be sold, rather than literal cash in the form of dollar bills.
Free Cash Flow Yield
The free cash flow yield is a number somewhat comparable to earnings per share. It looks at the total free cash flow of a company divided by its total market capitalization, or total stock value. At times, the complete enterprise value is used instead of market cap, especially if the company has a lot of debt investment.
The free cash flow yield essentially shows how much cash is available to the investors from the company's operations. A higher yield potentially means a more solvent company, since there's more cash available for unexpected costs.
- P - Wikipedia
- NYU Stern School of Business: Value/EBITDA Multiple
- Exit Promise: Market Value of Invested Capital
- CFI: Enterprise Value
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- Corporate Finance Institute: EV/Capital Employed Ratio
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Steven Melendez is an independent journalist with a background in technology and business. He has written for a variety of business publications including Fast Company, the Wall Street Journal, Innovation Leader and Ad Age. He was awarded the Knight Foundation scholarship to Northwestern University's Medill School of Journalism.