How useful is a p/e ratio?

The price/earnings (p/e) ratio is perhaps the most widely quoted figure in corporate analysis. But why is it so popular? And is there a more useful alternative?

What a p/e ratio tells you

The p/e ratio is popular partly because it's nice and straightforward. Say a company's share price is £5. Last year's earnings per share (EPS use profits after tax for the earnings figure) came in at 50p. So the p/e ratio is ten the share price divided by EPS (£5/50p). Roughly speaking, this means that ignoring the time value of money an investor paying £5 now is prepared to wait ten years (10 x 50p is £5) to get their money back, assuming future annual EPS is also 50p.

A p/e of 20, of course, does not suggest investors will wait 20 years to get their money back most won't. What it implies is that EPS is set to grow quickly, so that £5 invested now will be returned much quicker. Equally a low p/e ratio suggests a low future earnings growth rate. However that may be offset by a decent dividend yield (the income return on a share). For contrarian investors, very low p/e ratios can point the way to a bargain and high ratios suggest an expensive share we'd normally avoid. So far, so simple. But that's far from the whole story.

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What can go wrong?

Obviously, a p/e is hopeless for loss-making firms the result is largely meaningless when earnings are negative. It's also unreliable for firms with very volatile earnings. One answer is to use the Shiller p/e instead. Devised by Yale professor Robert Shiller, this uses an average of the last ten years' earnings per share to smooth earnings' volatility.

A p/e is also of limited use in sectors where earnings are not a key driver of investment returns. For example, in the investment trust or property sectors, many investors prefer measures based on assets under management. So a price-to-book-value ratio (the share price compared to net assets per share) may be better.

Enter EV/EBITDA

However, perhaps the biggest criticism levelled at the p/e is that it is mechanically flawed. By only using a share price, the p/e ratio ignores the market value of a firm's debt. That's vital for anyone planning to buy it. More importantly, says Ben Levinsohn in The Wall Street Journal, "the 'e' can't be trusted", for three main reasons.

First, earnings after tax can be affected by a firm's tax jurisdiction and accounting. So it's better to ignore tax. Secondly, true operational profitability (what a firm makes from its bread-and-butter activities) can also be affected by a firm's financing decisions. This is reflected in the interest charge in the profit and loss account. So it's better to state earnings before interest and tax. Thirdly, most firms' earnings are stated after deducting two subjective figures amortisation and depreciation. These are fairly arbitrary charges that reflect the wearing out of tangible (eg, machinery) and intangible (eg, patents) assets over their estimated useful life to a business.

EBITDA or earnings before interest, tax, depreciation and amortisation claims to cure these faults. By comparing enterprise value (the market value of a firm's debt plus its equity) to EBITDA you get a much more reliable valuation multiple, say fans. Like a p/e, the lower the ratio the better for bargain hunters.

Of course, the truth is that there is no magic number. Both p/e ratios and EV/EBITDA have their fans and their critics (for example, in capital-intensive sectors, stripping out the impact of capital spending by removing depreciation can be misleading this is partly solved through the modified number EBITA). So better to use more than one if a firm has both a low p/e and a low EV/EBITDA, you have better evidence that it may be a bargain.