POOR COMPANIES RICH MULTIPLES

Author: Preetam Mittal

               PGDM RM 2011-2013

               Welingkar Institute of Managament

The document is about common mistakes made by investors while analyzing the financial ratios and how companies manipulate their stock prices.

A premium earning multiple is hard to come to a company and even harder to maintain.

In the recent times when everybody seems to be in a hurry, investors too have discovered a quick short hand for their investment – P/E ratio.

Countless investors - individuals and professionals alike spend their time seeking out cheap stocks with very low P/E ratios. Sometimes the stocks are cheap for some reasons, they are not in favorable industries or have poor fundamentals hidden within. And as a result, the stock prices stay stagnant... sometimes for years.

But investors don’t understand this fact and companies take their advantage and modify the P/E ratio by various means – the most common been -inclusions of debt in the capital structure. When companies are financially leveraged then the one with higher debt in the capital structure has lower P/E ratio and is more preferable among its peers.

Exhibit 1

Leverage distorts the P/E ratio (Hypothetical case)

Exhibit1clearly shows that though both the company has same EV value, their P/E ratios have substantially changed due to inclusion of debt. Taking the example of two companies Apache Corp and Anadarko Petroleum, each of these energy firms in the year 2010 had an EV/EBITDA multiple of just over 5 (source: investing answers.com) the average EV/EBITDA multiple in their peer group was just under 7. That seems to indicate APA and APC were 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 of its net income.

Why PEG is better than P/E ratio?

There are more detailed valuation models available in the market which seldom makes the headline. These are generally the cause of concern for the senior executives as they claim that their company has great growth prospects and many investments projects in hand. Actually, they are not necessarily wrong. Even financial theories suggest that companies which have higher growth prospects should have higher earnings ratios and hence better market value.

But the problem with the P/E ratio is that it's a retroactive metric. It pits a company's current market cap against its trailing-12-month profit. But when you buy shares of a company, you're not purchasing its history - you're purchasing its future cash flows. What matters is what the company is going to do and not what it has done.

So what's the solution?

The solution is to account for the growth rate of the company or expected growth rate if it can be estimated. Thus, it gives birth to a new and better ratio - PEG ratio, the calculation is as follows:

PEG Ratio = Price-to-Earnings (P/E) Ratio / Annual Earnings per Share Growth

In fact, if one goes back a decade ago then one may find that Apple's P/E ratio at that time was as high as 297. So, anyone making investment on the basis of P/E ratios would not have considered it a very profitable investment but had you bought shares of the company then, you'd be up over 7,300% today.

But, if someone calculated the PEG ratio it would be something closer to 1. A crude analysis suggests that companies with PEG values between 0 to1 may provide higher returns (the closer to 0 the more undervalued).

Common manipulation techniques used by the management

There is another very common form of manipulation used by companies called the "big bath," and this can cause these stocks to seem undervalued to investors. This happens when the company incurs a big loss to their bottom line. This method involves the company taking the complete loss in one single period, instead of spreading these losses over years. This will cause the earnings per share to drop significantly for the time period involved, due to the large losses posted. The intention of the company is to foster the idea among investors that this charge is a once only deal, and that the stock will rise considerably after the loss has been absorbed. This will cause investors to see the stock as one of the undervalued stocks, or as an attractive investment and thus will cause the demand and price for the stock to jump up.

One must always keep in mind that using P/E ratios only on a relative basis means that your analysis can be skewed by the benchmark you are using. After all, there will be periods when entire industries will become overvalued. In 2000, an Internet stock with a P/E of 75 might have looked cheap when the rest of its peers had an average P/E of 200. In hindsight, neither the price of the stock nor the benchmark made sense. Just remember that being less expensive than a benchmark does not mean something is cheap, because the benchmark itself may be vastly overpriced.

These ratios are completely ineffective for cyclical firms that go through boom and bust cycles--semiconductor companies and auto manufacturers are good examples and these requires a bit more investigation. Although one would typically think of a firm with a very low trailing P/E as cheap, but that would precisely the wrong time to buy a cyclical firm because it means earnings have been very high in the recent past, which in turn means they are likely to fall off soon.

In a similar way, when you're looking at a P/E ratio, also make sure that the "E" part of the equation makes sense. A few things can distort the P/E ratio. First, firms that have recently sold off a business can have an artificially inflated "E" and a lower P/E as a result. The denominator of the ratio can be easily manipulated by changing the revenue recognition, depreciation and capitalizing cost methods the company have been following.

The company generally projects “pro forma” earnings, which shows the profit the company would have made in case some bad/extraordinary event didn’t happen. Consider the case of the attack on hotel T­­aj few months back. It would have surely affected its current earnings, but long term scenario remaining the same. Using Pro forma in those cases makes absolute sense to get an overall long term picture. But there are companies which excludes preferred stock dividends, taxes paid, bad investments, etc., and shows a very attractive pro forma earnings. Hence in general, it’s always better to forget about the pro forma earnings as more companies have come to misuse it, than guiding the stock holders.

Sometimes, companies may show an attractive figure as per-share earnings, but in the foot note it may take away a major part of it as special charges. In such cases investors usually do not pay attention or are ignorant about these facts but this ultimately affects the total earnings of the company and reduces the per-share earnings. Sometimes the special charges may not be really so special and it may show all its operating expenses and even losses as special charges.

Another common mistake made by investors in calculating the EPS is calculating it based on the number of shares currently available in the market and neglecting the convertible debentures available in the market. Companies generally issue fully convertible debentures in the market which the debenture holder converts into equity share when he/she finds the market lucrative. Here at any condition, one should only take the diluted earnings and also check if the company has any plans to dilute further, as it may take away another piece from your pie.

Why management manipulates financial statements?

There are three primary reasons why management manipulates financial statements. First, in many cases the compensation of corporate executives is directly tied to the financial performance of the company. As a result, management has a direct incentive to paint a rosy picture of the company's financial condition in order to meet established performance expectations and bolster their personal compensation.

Second, it is relatively easy to manipulate corporate financial statements because GAAP standards afford a significant amount of flexibility, making it very easy for corporate management to paint a favorable picture of the financial condition of the company.

Third, it is unlikely that financial manipulation will be detected by investors due to the relationship between the independent auditor and the corporate client. While these entities are touted as independent auditors, the firms have a direct conflict of interest because they are compensated by the very companies that they audit. As a result, the auditors could be tempted to bend the accounting rules to portray the financial condition of the company in a manner that will keep their client happy. Moreover, auditors typically receive a significant amount of money from the companies that they audit. Therefore, there is implicit pressure to certify the financial statements of the company in order to retain their business.

Conclusion

Are these ratios the “be all to end all” for pricing a share of stock for a company? Of course they aren’t. There are a lot of factors that go into pricing shares of stock and so it's important to continually sharpen one's skills and put new tools in the toolbox. It makes sense to go through and calculate different multiples such as EV multiple (EV/EBITDA, EV/EBIT), PEG and Dividend yield ratio etc. for all current holdings and for future investments.