Posted by lotsofmoney > 2013-04-08 11:50 | Report Abuse

Does PE ratio also cover debts (all types of company borrowings),risk in other dealings like derivatives or hedgeing or insurance/guarrentor for debts or borrowing and preferrencial shares, warrant and other entiltlement not included in the common shares?

Posted by kcchongnz > 2013-04-08 11:56 | Report Abuse

lotsofmoney brought up a very relevant point. PE ratio does not take into considerations of all the things mentioned. It gives us an illusion that two companies in the exactly same business with the same earnings per share has the same value, despite that one is having heaps of debts, and the other probably, heaps of cash.

That is why a better ratio should be enterprise value/Ebit, or ebitda; whereby all equity and debts are taken into considerations.

Posted by aunloke > 2013-04-08 14:13 | Report Abuse

To avoid the pitfall look at the interest coverage as well, no company can progress well if it spends large portion of its earning to service its deft.

Posted by kcchongnz > 2013-04-27 18:19 | Report Abuse

Two companies, A and B in exactly the same industry have the same number of shares with the same share price, and hence the same market capitalization of 100m as shown in Table 1 below.

Table 1
Company A B
No. of shares, m 100 100
Share price 1.00 1.00
Market Cap, m 100 100
Total debt, m 50 10
Excess cash 10 20

A has a total debt of 50 million and an excess cash of 10m, whereas B has a total debt of 10m but an excess cash of 20m. Table 2 below shows the income statements of the two companies:

Table 2
Company A B
EBIT 15.8 13.8
Interest -2.5 -0.5
EBT 13.3 13.3
Tax @ 25% -3.3 -3.3
Net income 10.0 10.0

Both companies make a net income of 10m. Hence both A and B is selling at a price-earnings ratio of 10 (100m/10m). But are they having the same value? If not, which company would you prefer to invest in?
One way to look at it is considering the total enterprise value (TEV) of A and B and see which one is cheaper to buy the whole business as explained below:

[Posted by Tan KW > Apr 8, 2013 12:04 PM | Report Abuse
Enterprise value is calculated as market cap plus debt, minority interest and preferred shares, minus total cash and cash equivalents.
Think of enterprise value as the theoretical takeover price. In the event of a buyout, an acquirer would have to take on the company's debt, but would pocket its cash.]

TEV of A is 140m (100+50-10) and B is 90m (100+10-20). B is clearly a cheaper and a better value buy. Debt and cash can have an enormous impact on a particular company's enterprise value. Hence when evaluating the fair price of a company or comparing companies, A better measure of value is the enterprise value over the earnings before interest and tax (EBIT), instead of the too simplistic or flawed PE ratio.

For Table 2 above, both A and B produce the same net income of 10m, but A has a higher EBIT of 15.8m and B a lower EBIT of 13.8m. However, the TEV/EBIT for A is 8.9 times (140/15.8), 36% higher than the 6.5 times (90/13.8) of B. Hence B is clearly a much better buy than A.
In term of return of capital, the ROC (EBIT/TEV) of B is 15.3% (13.8/90), which is much better than that of A of 11.3% (15.8/140), Although both has the same ROE of 10%.