Beware of relying solely on the P/E ratio for valuation

Sometimes, a quick and simple valuation method can be useful. The P/E (price/earnings) ratio is the one most commonly used when comparing the valuations of different companies and trying to calculate the value of one’s own. However, there are many potential pitfalls to this method.

What are multiples?
The principle is very simple. By looking at how similar listed companies are valued in relation their profits, a ratio is calculated and then used in the valuation. The method is based on the idea that the stock market is able to correctly assess the value of companies.

Weakness number one – the future is not taken into account
The most obvious problem is that this method does not take the future into account. Your company might have made large investments over the year, and therefore it may be anticipating high profits next year. If that is the case, multiples based on profits in the last twelve months will underestimate the value of your company.

Weakness number two – size is not taken into account
If you own a clothing store, it might be tempting to look at the ratio for H&M to get an indication of how the market values other clothing retailers. However, unless you also have 50,000 employees, and 5,000 shops in 40 countries, you have to adjust for the differences in size between H&M and your company. Another crucial factor is liquidity. H&M shares can be sold to millions of investors all over the world at the push of a button. In contrast, selling shares in a privately held company requires meticulous preparation and the number of potential buyers may be, at the very best, a few hundred.

There is no accepted truth, but in the Swedish mid-market segment for private companies, valuations are generally 20-30% lower than for comparable listed companies.

Weakness number three – the market is not always right
Some people are worried that the value of their company will decrease in the event of a stock market crash. A crash will of course affect the business negatively, but it will also expose another weakness of multiple valuation: the assumption that the stock market is capable of always valuing companies correctly. This is an assumption to be wary of, not least in a bull market.

Use EV/EBITDA instead
The P/E multiple is as simple as its use is widespread, but it can be very misleading when comparing companies with different degrees of leverage. The logic is simple: we need to use a valuation method that indicates the same value for a company regardless of its financing. Therefore, we here at Valentum mainly look at ratios based on a company’s EV—its enterprise value.

EV is put in relation to EBITDA, which is used as a proxy for the cash flow of a company. Another advantage with this ratio is that it is more difficult to manipulate for all the creative controllers in listed companies.