It seemed interesting so I looked into it. Unfortunately, I found another example of oversimplification of valuation leading to erroneous conclusions. PE is the market value of the company's equity divided by its net income. It excludes any debt the company has and includes all of the vagaries of net income (as opposed to cash flow). For every dollar of equity market capitalization this company had there were seven of debt. Debt included, it turned out to be one of the most expensive stocks in its industry – something Wall Street research had somehow overlooked.
It seems like stock analysts and popular media focus on PE while the bond/debt markets use EV/EBITDA. I would love to understand why Wall Street leans so much on PE when I’ve found it close to irrelevant in real fundamental analysis (seriously, if you know why or have any ideas, please email me).
There is no one catch-all metric to look at when investing. One of several I use is EV/EBITDA (EV = enterprise value = equity market cap + debt - cash), (EBITDA = earnings before interest, taxes, depreciation and amortization). The most important indicator of long-term corporate value is cash flow. EBITDA is one proxy for cash flow, operating cash flow is another, but neither are perfect. You also have to look at CAPEX (capital expenditures), working capital requirements, and other impacts. EBITDA tries to zero in on the health of the underlying cash flow of the business and eliminate irrelevant 'noise' or accounting gimmicks. Interest is removed because it is the result of how management has decided to capitalize the business and the interest rate environment (if you're using EV it’s not as relevant to the health of the operating business). Taxes are a consequence of the jurisdiction, any one time tax breaks, and other factors that can be distorted in the short term. Depreciation and amortization are not cash items and can be the result of a number of factors unimportant to the underlying business (for example, high amortization of intangible after an acquisition).
I’ll leave you with one example. Take a company that has a market cap of $100, a debt of $1,000, and generates $50 of net income. Sure, your PE is 2, but this company will likely file for bankruptcy and the equity will be wiped out. While most cases are not as obvious, just remember when you're buying a stock you're buying both the equity and assuming the debt liabilities, aka EV.
