Jelly Roll Capital Equity Research

Dissecting the Price-to-Earnings (P/E) Ratio: Part II

Yesterday we took a look at the usefulness of the Price-to-Earnings (P/E) ratio, and how to get a more complete view of the price of a company. That concluded with changing the “price” in P/E from market capitalization to Enterprise Value (EV) to represent how much cash and debt the company is carrying on its balance sheet. Right now, our formula is EV/E, but we can improve on that too. How? By finding a more accurate measure of earnings. In the typical P/E formula, earnings is simply the company’s net income over the trailing twelve months, denoted “ttm”. While net income is an easy measure to compute, it is far from the best representation of how much money a company makes. Here is why…

 

AMERCO (ticker: UHAL) is the parent company of U-Haul, the do-it-yourself moving company that rents trucks, vans, and trailers. UHAL currently has a market capitalization of $1.32 billion, and a P/E of 13.6, which is a reasonable valuation if taken at face value. As we learned previously though, we need to adjust the “price” from market capitalization to enterprise value, which for UHAL is $2.06 billion as of today’s close. Substituting EV for P in P/E gives us our current valuation formula of EV/E; for UHAL this new ratio is 21.7 - showing the company is not nearly as inexpensive as initially thought. The “earnings” we are using for this calculation is net income, which was about $95 million for UHAL in the last year. Net income isn’t the most accurate way to judge UHAL’s actual earnings, however, because the company needs to make capital expenditures (the purchase of long-lived assets) in order to continue operating. How much did these capital expenditures cost UHAL in the last year? Nearly $545 million. That spending is not included on the income statement; to find it, you need to read the Statement of Cash Flows. This brings us to the metric we should use to judge how a company is valued: free cash flow (FCF). Without getting into an overly complicated explanation of how to derive FCF, accept for now that FCF tells us how much money the company has generated that it can use to enhance shareholder value through buybacks, dividends, or reinvesting in the company. Right now, UHAL has no free cash flow, as all net income )plus other money, as FCF is currently negative) goes right back into the business. As you can probably deduce, the metric I use to quickly evaluate companies (and I think you should use too) is EV/FCF.

 

Although EV/FCF is, in my opinion of course, the best way to value a single company, for comparison purposes I recommend first using EV/EBIT (earnings before interest and taxes) or EV/EBITDA (earnings before interest, taxes, depreciation, and amortization). Using the former will neutralize the effects of differences in financing structures and current tax efficiency, whereas the latter will also eliminate the effects of the accounting choices that go into calculating depreciation and amortization. Of course, after you do this, you should still use EV/FCF, but I’ve found the EBIT and EBITDA can often help streamline the process of narrowing down companies.

 

Next: Free cash flow is a non-GAAP accounting measure, which means there is no one set way to find its value. What, then, is the best way to find free cash flow?

Market Analysis, Education, and Wall Street-Quality Stock Reports