The Best Alternative to the Flawed P/E Ratio

Investors have clung to the price-to-earnings (P/E) ratio for more than seven decades. It's a simple way to get a sense of how a company's market value compares to its earnings. But there's a pretty significant problem with P/E.

Neither the "P" nor the "E" is an especially accurate gauge.

As I'll illustrate, a company's stock price is not a wholly accurate gauge of a company's value in the real world. And earnings, as we learned in the Enron/Worldcom era, can be easily manipulated.

Instead, if you want to really get a sense of a company's value relative to other firms, you should familiarize yourself with its enterprise value (EV) and EBITDA.  

A Flawed Metric
It's pretty easy to see why market capitalization (stock price multiplied by the number of shares outstanding) is a flawed metric. Let's look at two companies that both have a market capitalization of $500 million ($10 stock price multiplied by 50 million shares outstanding) and $50 million in profits. The first company has $100 million in cash while the other carries $100 million in debt. Surely you'd prefer that cash rich company, all other things being equal.

And that's where EV comes in. You simply add the firm's debt to its market capitalization and then subtract its cash in order to get to enterprise value.

Enterprise Value = Market Capitalization + Debt - Cash

In this instance, the company with all that cash is more inexpensively valued ($500 million + $0 - $100 million = $400 million) compared to the debt-laden firm ($500 million + $100 million - $0 = $600 million).

In a similar vein, it's incredibly important to assess the impact that debts and cash balances have on profits. You can figure out what profits look like before interest expense (on that debt) and interest income (on that cash) by using EBITDA (earnings before interest, taxes, depreciation and amortization). In the example above, let's go on to assume both companies have $50 million in profits, but EBITDA of $60 million. [Learn how to calculate EBITDA and see an example.]

In this instance, the company with an EV of $400 million and EBITDA of $60 million has an EV/EBITDA ratio of about 6.7 ($400 million/$60 million = 6.7). The other company, the one with all the debt, has an EV/EBITDA ratio of 10 ($600 million/$60 million = 10). Just like the P/E ratio, a lower EV/EBITDA ratio is always more appealing (more company for your dollar). But unlike the P/E ratio, the EV/EBITDA ratio is difficult to manipulate.

Real World Example in the Oil and Gas Industry
Investors often use this formula when looking at firms with a high degree of depreciation or high levels of debt. EV/EBITDA is especially useful when looking at oil and gas drillers. EBITDA works best because reported earnings can become very distorted by accounting rules as oil and gas wells are slowly depleted and must be written off (against earnings) over time. And enterprise value is more helpful than market value because it ensures debt-laden companies are valued on a truly equivalent basis versus those that use more judicious levels of debt.

Let's look at two of the hot names in the oil and gas sector. Analysts are currently recommending shares of Apache Corp (NYSE: APA(link is external)) and Anadarko Petroleum (NYSE: APC(link is external)).  Each of those energy exploration firms has an EV/EBITDA multiple of just over 5 (based on projected 2010 EBITDA) while the average EV/EBITDA multiple in their peer group is just under 7. That seems to indicate APA and APC are relatively undervalued.

But if you looked at Anadarko strictly on a P/E basis, you'd wonder why shares hold any appeal, trading at nearly 30 times projected 2010 net income.

As an investor, it's important to continually sharpen your skills and put new tools in the toolbox. And it makes sense to go through and calculate EV/EBITDA for all your current holdings. You especially want to look at how they compare to other companies in their industries. If they sport a much higher EV/EBITDA ratio (even if the P/E ratio looks more reasonable), then that might tell you it's time to sell. If the EV/EBITDA ratio is much lower, it may be time to buy some more.