Article Finsight of the Month Cover Story
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NIVESHAK
Poor Companies - Rich Multiples Preetam Mittal
Welingkar Institute of Management
A premium earning multiple is hard to come to a company and even harder to maintain. In recent times when everybody seems to be in a hurry, investors too have discovered a quick short hand for their investment – P/E ratio. Countless investors, individuals and professionals alike, spend their time seeking out cheap stocks with very low P/E ratios. Sometimes the stocks are cheap for negative reasons like uncomplimentary industries or poor fundamentals hidden within. And as a result, the stock prices stay stagnant... sometimes for years. But sometimes investors do not pay attention to this fact and companies take undue advantage and modify the P/E ratio by various means – the most common being inclusions of debt in the capital structure. When companies are financially leveraged then the company with higher debt in the capital structure has lower P/E ratio and is more preferable among its peers. Company with debt
Company with only equity
50
50
Taking the example of two energy firms Apache Corp (APA) and Anadarko Petroleum (APC), each
with an EV/EBITDA multiple of just over 5 in the year 2010, the average EV/EBITDA multiple in their peer group being just under 7. This seems to indicate APA and APC were relatively undervalued. However, looking at these companies strictly on a P/E basis, one would wonder why shares in these companies hold any appeal when they are trading at P/E multiple of nearly 30x.
There are more detailed valuation models available in the market that incorporates not only the past Interest -20 0 performance but also forecast future ones. However, Net Income 30 50 these models are complex for the general investing Enterprise Value 1,000 1,000 public and they seldom make the headline. This is (EV) generally a cause of concern for senior executives Debt -500 0 as their claim that their company has great growth Market Capitaliza500 1000 prospects and many investments projects in hand tion are not properly valued in their company’s stock EV/EBITA 20.0x 20.0x price. Actually, they are not necessarily wrong. Even Debt/Interest 25.0x N/A financial theories suggest that companies which 16.7x 20.0x P/E Ratio have higher growth prospects should have higher earnings ratios and hence better market value. Table 1: Leverage distorts the P/E ratio (Hypothetical case) But the problem with the P/E ratio is that it’s a Table 1 clearly shows that though both the com- retroactive metric. It pits a company’s current marpany has same EV value, their P/E ratios have ket cap against its trailing-12-month (TTM) profit. changed substantially due to inclusion of debt. But when you buy shares of a company, you are Earnings (EBITA)
.. Countless investors, individuals and professionals alike, spend their time seeking out cheap stocks with very low P/E ratios
June 2012