13 Jan 2018

The following paragraph is not true. A neat way to value a company is to divide the share price by the earnings per share (EPS) which gives you something known as a P/E (price/earnings) ratio. A low P/E ratio (say <10x) implies that a share is cheap and a high P/E ratio (say >20) suggests expensive. Many people, some of them claiming to be investment professionals or financial journalists, still promote P/E ratios (which came to be the standard valuation method in the 1970s and the 1980s). Here are some reasons why they are wrong. MARKET CAPITALISATION IS NOT THE VALUE OF THE COMPANY The price of a share is a measure of one of a company’s liabilities (the equity owned by shareholders) but not the value of the company. The equity is what is left over after all other obligations have been met. The value of the equity is known as the market capitalisation of the company. EI Group (formerly Enterprise Inns) has 479.5 million shares trading at 143p giving it a market capitalisation of £685 million. Also with a market capitalisation of £685 million is Go-Ahead Group with 43.2 million shares at 1586p. Their earnings per share last year were 20.5p (EI Group) and 207.7p (Go-Ahead) giving them P/E ratios of 7.0x and 7.6x respectively. How cool is that? Are they both cheap and are they almost equally cheap? You will not be surprised to read that it’s not as simple as that. The balance sheet of EI Group reveals that it the business is carrying more than £2000 million of net debt whereas Go-Ahead has £200 million of net cash. Consequently, the enterprise value of EI Group is £2700 million (market capitalisation plus net debt) and Go-Ahead’S enterprise value is just £485 million (market capitalisation minus net cash). On that basis the pub leasing business is worth 5.6x as much as the bus and train operating business. This doesn’t tell us which share is more likely to go up but it gives us plenty of ideas about what might influence their prices. None of which involve reported EPS. EARNINGS PER SHARE Another reason why P/E ratios are nearly useless is that...