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Jelly Roll Capital Equity Research |
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Market Analysis, Education, and Wall Street-Quality Stock Reports |
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Dissecting the Price-to-Earnings (P/E) Ratio: Part I |
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One of the most frequently discussed, and often misunderstood, investing topics is the price-to-earnings (P/E) ratio. What does the P/E ratio tell us? Simply put, the “price” in P/E is the market capitalization of the company, and the “earnings” is the company’s net income, usually denoted with “ttm” for “trailing twelve months”. Dividing price by earnings shows how much people are paying for one dollar of the company’s net income. Presented this way, the P/E ratio seems like an invaluable tool for assessing a company’s valuation - which isn’t really true. The P/E ratio is subject to a number of problems with inputs that distort the end P/E, which is why I believe that P/E is an over-hyped and largely useless measure. Lets examine an example…
Qwest Communications (ticker: Q) is a telecom company with both wireline and wireless services. The company’s market capitalization on its most recent close was $16.2 billion, and the net income over the trailing twelve months was $593 million. Doing a simple P/E calculation pegs the company as trading for about 27x ttm earnings, which is above average but not indicative of an enormously overvalued company. What this calculation ignores, however, is the more than $13 billion in long-term debt Qwest is carrying. For those of you familiar with the accounting equation of Assets = Liabilities + Stockholder’s Equity or the Modigliani-Miller Theorem will know that the total market value of a firm is independent of how it chooses to finance itself; Qwest has chosen to partially use debt. The true “price” of the company is not the market capitalization, but rather a term called “enterprise value” (EV), which is the market capitalization plus debt minus cash. EV more accurately represents the value of the firm because a buyer would need to assume debt, but would also have access to the company’s cash. Qwest’s EV is about $29 billion, and if we substitute EV for the P in P/E, we now have EV/E - which for Qwest is about 49x ttm earnings. Using this more stringent method of accounting, we can see that Qwest is significantly more expensive than it initially appears using a simple P/E ratio. |