P/E and P/BV ratios (Polish abbreviations C/Z and C/WK meaning Price/Net Profit and Price/Book Value, respectively) are commonly used indicators in the valuation of enterprises and companies. Many newspapers and portals provide only these indicators for listed companies, thus emphasizing their importance. We have only one problem - these indicators are generally not suitable for professional company valuation and their use may significantly distort the real value of the company or enterprise.

Company valuation - comparable company method - P/E ratio

Let's first analyze the P/E ratio. The main objection to this indicator is the complete disregard of the Debt/Equity (D/E) financing structure. If comparable companies have a financing structure that is significantly different from the company being valued, we may obtain distorted results in the valuation.

Let a simple example illustrate the importance of the problem.

The financial data of company A that we want to value are as follows:

 All values ​​above are given in millions of PLN, except for the number of shares presented simply in millions.

Let's assume that our valued company has a D/E financing structure generally corresponding to listed companies in this sector and the P/E ratio for these companies is 11.0. Let's ignore the issue of premium/discount due to liquidity and control (this is a real Pandora's box...) and estimate the value of one share of company A.

The matter seems to be child's play - the adopted P/E ratio is multiplied by the net profit of company A and then divided by the number of shares:

11.00 x PLN 44.55 million / 100.00 million = 4.90 PLN

Now imagine that for certain reasons (e.g. the threat of takeover of the issued bonds by a market competitor and, consequently, the risk of access to confidential information), company A decides to issue shares in order to redeem bonds worth PLN 400 million. This means that after the buyout transaction, the financing structure will change significantly - bank loans and bonds (D - debt) will amount to PLN 300 million, and financial capital will amount to PLN 700 million (E - equity). How many shares should we issue to have enough to buy back the bonds? The answer is simple - if we believe that the fair value of one share is PLN 4.90 and we are willing to sell it for that much, then the number of new shares should be 400 million PLN / 4.90 PLN - i.e. 81.624 million shares.

Assuming that we do everything immediately, what will the financial data of company A be like then - after changing the D/E financing structure?

 Since the debt of D has decreased to 300 million PLN, financial costs will decrease accordingly and net profit will increase accordingly.

Let's assume for a moment that the P/E ratio of 11.00 should continue to be used and let's value one share. Calculating the value of one share is simple:

11.00 x 60.75 million PLN / 181.62 million = 3.68 PLN

We are in cognitive shock - after all, just before the financing restructuring, we estimated the value of one share at PLN 4.90, where does this 25% drop come from? Operating profit has not changed as a result of the change in the structure of financing of operating activities...

Now let's do the opposite - let's assume for a moment that the fair value of one share of company A is still PLN 4.90; what will the corresponding P/E ratio be like now? P/E calculations are trivial:

4.90 PLN x 181.62 million / 60.75 million PLN = 14.65 – increase by 33%...

The conclusion from this simple example is clear - the P/E ratio should not be used in the valuation of companies because it distorts the value of the company when the D/E financing structure of the company being valued is different from that of comparable companies listed on the stock exchange.

The second reason why we should be skeptical about the P/E ratio is that the issue of non-operating assets has been completely ignored. Such assets may be stocks or shares in entities from another sector, cash, purchased bonds, unused plots of land, monuments, etc. From a rational point of view, if our valued company had such assets, they should be somehow included in the valuation of the company's value. Very often it is not because such assets may not generate revenues and/or profits recognized in the profit and loss account despite having significant value. A good example would be owning minority stakes in growth companies that conduct intensive investment programs and, as a result, do not pay dividends. Another example is unused plots of land which, instead of profits, may only generate costs - real estate tax, perpetual usufruct fees, utilities.

Company valuation - comparable company method - recommendations for the P/E ratio

What if, despite all these reservations, we are determined to use the P/E ratio in the company's valuation?

Firstly, when calculating the Price (i.e. the so-called capitalization), the number of shares issued, excluding treasury shares, should be taken into account - this applies to both comparable companies and the company being valued. Referring to my previous note A good change in accounting. Own shares. , remember that in accordance with the change in the Accounting Act, treasury shares are now recognized as a separate asset; entities applying IAS/IFRS recognize equity shares in equity with a negative sign, while entities applying other accounting standards, with a probability bordering on certainty, also recognize equity shares in equity with a negative sign.

Secondly, if the entity prepares consolidated financial statements, we obviously take into account the net profit from the consolidated profit and loss account, but only in the part attributable to the shareholders of the parent company - we value the shares of the parent company, so the part of the consolidated net profit that is attributable to to minority capital is not within our scope of interest. If we are not dealing with a capital group - i.e. no consolidated report - then the thing is simple - we take into account the entire net profit from the separate profit and loss account.

Third note - we try to take into account the most recent representative net profit for the annual period. Taking into account quarterly or half-yearly data with a simple linear approximation may be questionable due to seasonality factors and the fact that certain adjustments (e.g. write-offs) are very often made once a year only when preparing the annual report.

Company valuation - comparable company method - P/BV ratio

Now let's spend some time on the P/BV ratio used to value companies. Why is it inappropriate? The reasons are:

• inability to take into account the profitability of the valued enterprise - in fact, the valued entities should be at a similar level of profitability as comparable companies for the results of value comparisons to be reliable; otherwise our comparison will have no logical basis;

• not taking into account the D/E financing structure - the same reservation as for the P/E ratio; and again, the company being valued should have a similar financing structure to comparable companies, otherwise the use of the indicator may give distorted results;

• lack of actual possibility to take into account different accounting policies of the valued entity and public comparable companies - usually in the valuation process we have sufficient access to the company being valued and we are able to obtain knowledge about the accounting principles used, the situation is much worse for comparable companies - not all relevant information from from a valuation point of view, may be included in the financial statements; differences in the accounting policies used may affect the denominator - the book value of equity; in particular, these differences may be significant in the area of ​​recognizing intangible assets and applying fair value versus acquisition cost for assets and liabilities for the purpose of preparing financial statements.

Let's go back to our example. What is the P/BV ratio before the restructuring of the D/E financing structure? The answer is simple 490.05 / 300 = 1.63.

What does the P/BV ratio look like after changing the financing structure?

Let's consider two cases:

• P/BV = 668.25 / 700 = 0.95 - assuming the P/E ratio remains at 11 (decrease in the value of 1 share to 3.68 PLN)

• P/BV = 890.05 / 700 = 1.27  - assuming the value of 1 share remains at 4.90 (an increase in the P/E ratio to 14.65).

Company valuation - P/E and P/BV ratios - summary

Let's take a summary of the changes in the P/E and P/BV ratios resulting from the change in the financing structure. Given the lack of change in operating profitability, are such significant fluctuations in indicator values ​​credible? In my opinion, they are not and these changes prove how the use of these two indicators can distort the fair value of the company or enterprise being valued.

The question then is - why are these indicators so widely used? The only answer that comes to my mind is simplicity. The use of these indicators is generally simple, even very simple. This simplicity becomes only slightly complicated when we want to take into account my three ordering recommendations (no treasury shares, part of the net profit attributable to the shareholders of the parent company in the consolidated profit and loss account, no simple linear approximation for quarterly or half-year results).

But as we saw in the example above, this simplicity simply leads to incorrect and distorted valuation results.

I also have a second, alternative, humorous reason for the widespread use of P/E and P/BV ratios - as a long-time fan of the X Files series with Agent Dana Scully and Agent Fox Mulder, I would also point to the possibility of a global conspiracy...

Seriously, what indicators should be used in the valuation of companies using the comparable company method (index method)? Here's a hint: EV / EBIT; EV/EBITDA; EV / EBITA…

A minor drawback when using these indicators is that the calculations are a bit more complicated. But believe me, just a little...