You will be able to spot when a multiple looks cheap or dear for the wrong reasons.
A friend of Marcus bought shares in a made-up container shipping line at a P/E of 6. Freight rates were at a record, profit had quadrupled, and the shares looked absurdly cheap against the market. A year later freight rates had halved, profit had fallen by four fifths, and the shares were a third lower. On the new, smaller profit the P/E was 20. Nothing about the company had been hidden. The multiple had simply measured it at the worst possible moment.
Lesson 9.1, P/E, EV/EBITDA, P/B, P/S and FCF yield: what each measures, set out what each multiple compares. This lesson covers the three situations where a multiple gives the wrong impression with the right arithmetic: the business cycle, debt and accounting choices, using made-up figures throughout.
Here are the shipping line's earnings per share over five years: 40 cents in the boom year, then 8, 12, 20 and 15 cents. At the peak the shares traded at S$2.40, a P/E of 6. A year later, at S$1.60 on earnings of 8 cents, the P/E was 20.
The pattern is reliable enough to have a rule of thumb behind it. When a cyclical company's profit is at a peak, investors expect it to fall, so they pay a low multiple of it. When profit is at a trough, they expect recovery and pay a high multiple of a small number. Buying because the P/E is low and selling because it's high does exactly the wrong thing with these companies.
The fix is to value the company on earnings through a whole cycle rather than one year. Normalised earnings are the profit a business would earn in an average year of its cycle. The simplest version is the average over a full cycle: here, 40, 8, 12, 20 and 15 cents average 19 cents. On that basis the shares at S$2.40 traded at about 12.6 times normalised earnings, not 6, and at S$1.60 at about 8.4 times, not 20. The boom-year price was the expensive one.
A better version averages margins rather than profit, then applies the average margin to current revenue, because revenue often grows across the cycle. Larkspur is a mild cyclical, and its operating margin, from lesson 7.2, Income statement: revenue quality, margin stack and one-offs, ran from about 11% in the FY4 trough to 16% at the FY3 peak and averaged about 13.4%. Apply that average to FY5 revenue of S$400 million and operating profit would be about S$53.6 million instead of the S$56 million reported. After interest and tax that's about 13.7 cents a share, a normalised P/E of about 11.7 against 11.4 on actual underlying profit. FY5 sits close to the middle of Larkspur's cycle, so its P/E isn't badly flattered. Check that before you compare it with a peer measured at its own peak.
Take two made-up companies with identical businesses, each with operating profit of S$50 million and each valued by the market at an enterprise value of S$500 million, so both trade at 10 times EBIT. Company A has no debt, while Company B has borrowed S$300 million at 5% and holds no spare cash.
Company A's profit after 17% tax is about S$41.5 million on equity worth S$500 million: a P/E of about 12. Company B pays S$15 million of interest, which leaves profit of about S$29 million on equity worth only S$200 million, the S$500 million less the debt. Its P/E is about 6.9.
On P/E, B looks far cheaper. It isn't, since the business and its total value are the same. The low P/E is the market charging for risk, because B's shareholders now stand behind S$300 million of lenders. Let operating profit fall 20%, to S$40 million, and A's profit falls 20% too. B's falls to about S$20.8 million, a drop of about 29%, because the interest bill doesn't shrink. Debt magnifies every swing in profit for the shareholders, which is why the equity deserves a lower multiple. EV/EBIT and EV/EBITDA show the two companies as what they are: the same price for the same business.
Multiples compare one line of the accounts across companies, so anything that changes that line without changing the business distorts the comparison. Two choices do most of the damage.
Leases come first. Under SFRS(I) 16 and IFRS 16, most lease costs leave operating expenses and reappear as depreciation and interest, both below EBITDA. Under US GAAP, an operating lease still shows a single lease cost inside operating expenses, above EBITDA. Imagine a US-reporting twin of Larkspur paying the same S$8 million a year for its factory land. Its EBITDA would be about S$72 million, not S$80 million. If a data provider then leaves the lease liability out of enterprise value, the twin trades at about 6.7 times EBITDA while Larkspur trades at 6.25, with nothing different but the rulebook. Lesson 6.4, Notes to the accounts: revenue, segments, leases and debt, showed where to find the lease figures that let you put both on the same basis.
Capitalising and depreciating costs is the second choice. A company that capitalises development spending, recording it as an asset and depreciating it over several years, reports higher EBITDA than one that expenses the same spending as it goes. Depreciation lives then move EBIT and P/E. Spread S$100 million of machines over ten years and the yearly charge is S$10 million; spread it over five and the charge doubles. Neither company is lying, yet their P/E ratios aren't comparable until you adjust. The accounting policies note says which choices each company made.
When one company looks much cheaper than its peers on a multiple, ask three questions before you believe it. Is its profit at a peak or a trough of its own cycle? Does it carry much more debt than the others? Do its accounting policies on leases, development costs and depreciation differ from theirs? Most large gaps turn out to have one of these answers. The ones that survive all three are worth your time.
For the activity, pick a company whose profits clearly rise and fall with a cycle, such as a shipping line, a commodity producer or a chipmaker, and find its earnings and share price in its last peak year and its last trough year.
Find one cyclical company and compare its P/E at its last earnings peak with its P/E at the last trough.
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