The Use of Earnings Multiples
Earnings multiples, particularly the P/E ratio, are a common shorthand for summarizing a company's value. We showed in Chapter 2 that value and earnings multiples can be explained by ROIC and growth. In practice, though, analyzing and interpreting earnings multiples can be messy. Even worse, a superficial analysis of earnings multiples can be misleading. This appendix explains some of the techniques behind a thorough analysis of multiples, to help you avoid misleading results.
A company recently asked us what could be done to increase its earnings multiple. The company was trading at a P/E multiple of 11 times, while most of its peers were trading at a P/E of 14, a discount of 25 percent. The management team believed the market just didn't understand its strategy or performance, but it turned out that this company had much more debt than its peers. We estimated that if the company had the same relative debt as its peers, its P/E would also have been about 14.
The difference was pure mathematics, not judgment by investors. Everything else equal, a company with higher debt will have a lower P/E ratio. The economic explanation is that companies with higher debt levels are riskier and, therefore, have higher costs of capital—which translates into lower P/Es.
This example points out the pitfalls in the superficial use and interpretation of earnings multiples. You have to dig into the accounting statements to make sure you're comparing companies ...