How to measure value?
There are many ways to measure value –
EV/EBIT or EV/EBITDA
replacement value multiples
However you measure it, value is designed to capture the idea that you’re “getting a deal.” P/E and EV/EBIT(DA) type measures reflect this by showing you how quickly you can earn your initial investment back …. A P/E of 20 means that each year you get 5% of your initial investment. A P/E of 3 you therefore mean that each year you get back 33% of your investment. Seems like a steal of a deal, right? 3 years and then it’s gravy. Unfortunately, most of the time, there is a reason that a P/E is 3 … specifically, markets anticipate that earnings are going to fall. If you look at companies with a 2-3 P/E – there are 7 of them below – you can see that in some cases (UAL, MTG, BPT), earnings have been falling. In another case, SDLP, there has been an unusually high earnings number in the recent quarter. For CBB, ARC and ESI, earnings are volatile. The one thing we don’t see for these 2-3 P/E companies is a consistently increasing earnings stream ….if so, it would be valued much higher.P/B is similar, but different. P/B and replacement value multiples, or multiples against reserves for commodity firms capture the deal you are getting on value – in this case, a low multiple may capture some hidden impairment of the assets of the firm. Perhaps the value reserves or machines are being marked to on the books is too high.
|BPT||BP Prudhoe Bay||15,043,999.77||31,508,000.06||43,378,000.73|
|ARC||ARC Document Solutions||3,183,999.96||80,335,999.25||-2,327,000.01|
|ESI||ITT Educational Services||10,446,999.86||1,688,000.00||14,917,000.10|
Skimming through the list of companies with 10-20% Price to book ratios (the company trades at 10-20% of book equity), there are 13: half are oil and gas and hal fare financials … again situations where it’s easily possible for book value to be way too high (given the recent fall in the price of oil, oil and gas equipment may easily be worthless; and financial assets such as bad loans can also easily be worthless).
So there are good reasons why P/E and P/B type ratios can be low – on average, they seem unjustifiably so, as these firms, on average, outperform, but if you own these firms, be prepared for decreasing earnings, writedown of assets and other things that accompany low multiples.