Pitfalls of P/E Multiple

On official websites and trading platforms, you will often find the P/E ratio, which typically refers to the ratio of a stock’s price to its earnings over the past 12 months (per share). Many people invest based on this metric, but in the modern investment world, this approach is no longer viable…

The P/E ratio does not take into account non-operating income and expenses on one hand and financial leverage on the other. Therefore, to compare apples to apples, metrics like EV/NOPAT or EV/EBITA are used. The table shows how financial leverage distorts the P/E multiple.

Here is a comparison of two companies, A and B. Because the fact that EV/EBITA is lower than the DEBT/Interest ratio, financial leverage results in a lower P/E. In contrast, the opposite scenario is observed when comparing organizations B and C.

Source:
#VALUATION – Measuring and Managing the Value of Companies, 7th Edition
McKinsey & Company,
Tim Koller, Marc Goedhart, David Wessels