Forward P/E or trailing P/E?

The forward P/E is based on what the company is expected to earn a year in the future. And the trailing P/E is based on what the company earned in the previous year. The difference between a trailing and forward P/E can be dramatic.

Which P/E should you pay attention to? The answer is, both. It's especially important now to consider both because future earnings are so unpredictable.

Rather than trying to pick which P/E ratio to use, compare them with each other. If you see a big difference between the two, you might learn more about the company's valuation if you find out why the forward and trailing P/E are so different.

For instance, if you notice that a stock has a high double-digit trailing P/E and a low forward P/E, you know that analysts are predicting earnings to recover sharply, but investors aren't believing the estimates yet. In that situation, if the company delivers as analysts hope, there could be a nice upside for the stock.

Similarly, if a stock's trailing P/E is low but the forward P/E is high, it might be a clue that analysts are being extremely bearish about the company's future, which might be a warning to you. On the other hand, this situation might mean investors are being overly optimistic about a stock's future, and they could be in for a rude awakening.

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EV/EBITDA and its Importance

EV/EBITDA is a valuation multiple that is often used in parallel with, or as an alternative to, the P/E ratio. The term EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation and Amortization. The main advantage of EV/EBITDA over the PE ratio is that it is unaffected by a company's capital structure. It compares the value of a business, free of debt, to earnings before interest.

If a business has debt, then a buyer of that business clearly needs to take account of that in valuing the business. EV includes the cost of paying off debt. EBITDA measures profits before interest and before the non-cash costs of depreciation and amortisation. EV/EBITDA is harder to calculate than PE. It does not take into account the cost of assets or the effects of tax. As it is used to look at the value of the business in EV terms it does not break this value down into the value of the debt and the value of the equity.

The first advantage of EV/EBITDA is that it is not affected by the capital structure of a company, in accordance with capital structure irrelevance. This is something that it shares with EV/EBIT and EV/EBITA. Consider what happens if a company issues shares and uses the money it raises to pay off its debt. This usually means that the EPS falls and the PE looks higher (i.e. the shares look more expensive). The EV/EBITDA should be unchanged. What the “before” and “after” cases here show is that it allows fair comparison of companies with different capital structures.

EV/EBITDA also strips out the effect of depreciation and amortisation. These are non-cash items, and it is ultimately cash flows that matter to investors.

When using EV/EBITDA it is important to ensure that both the EV and the EBITDA used are calculated for the same business. If a company has subsidiaries that are not fully owned, the statement of income shows the full amount of profits from but is adjusted lower down by subtracting minority interests. So the EBITDA calculated by starting from company's operating profits will be the EBITDA for the group, not the company. There are two common ways of adjusting for this:

·         Adjust the EV by adding the value of the shares of subsidiaries not owned by the company. The end result is an EV/EBITDA for the group. This becomes complicated if there are a lot of subsidiaries.

·         Include only the proportion of EBITDA in a subsidiary that belongs to the company. So if the company has a 75% stake in a subsidiary, only include 75% of the subsidiary's EBITDA in your calculation. This is simple for companies (such as many telecoms companies) that disclose proportionate EBITDA. Otherwise, it can become difficult if the subsidiaries' results are not separately available. It also needs the corresponding adjustment to EV. In the example above, only 75% of the subsidiary's debt would be included in the group EV.

Given these complications, a sum of parts valuation may be considered as an alternative for complex groups. EV/EBITDA could still be used to value each individual part of the group.

EV/EBITDA is usually inappropriate for comparisons of companies in different industries, as their capital expenditure requirements are different. Ideally one would substitute EBITDA minus maintenance capex (capital expenditure required if the business does not expand) for EBITDA, which is difficult. Alternatively, depreciation could be used as an inaccurate but easy proxy for maintenance capex which would mean using EV/EBITA.

Also, see EV/Sales and its Importance. See the space for more on Valuation Ratios......... 

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EV/Sales and its Importance

A Ratio (“EV/Sales multiple”) which compares the enterprise value of a company to the company's sales. EV/sales gives investors an idea of how much it costs to buy the company's sales. This measure is an expansion of the price-to-sales valuation (P/E ratio), which uses market capitalization instead of enterprise value. EV/sales is seen as more accurate because market capitalization does not take into account the amount of debt a company has, which needs to be paid back at some point. Generally the lower the EV/sales the more attractive or undervalued the company is believed to be.

EV/Sales = (Market Cap + Debt + Minority Interest + Preferred Shares - Cash and Cash Equivalents)/Annual Sales

The EV/sales measure can be negative when the cash in the company is more than the market capitalization and debt structure, signaling that the company can essentially be bought with its own cash.
The EV/sales measure can be slightly deceiving: a high EV/Sales is not always a bad thing as it can be a sign that investors believe the future sales will greatly increase. A lower EV/sales can signal that the future sales prospects are not very attractive. It is important to compare the measure to that of other companies in the industry (i.e. the peer groups), and to look deeper into the company you are analyzing.

Importance of EV/Sales in Mergers and Acquisitions:

In a M&A deal the seller will always try his best to value the company at as high of a price as possible, while the buyer will try to get the lowest price that he can.  To work a sort of a compromise between the two there are
many legitimate ways to value companies. The most common method is to look at comparable companies in an industry using comparative ratios: 

The following are two examples of the many comparative metrics on which acquiring companies may base their offers:

•  Price-Earnings Ratio (P/E Ratio) - With the use of this ratio, an acquiring company makes an offer that is a multiple of the earnings of the target company. Looking at the P/E for all the stocks within the same industry group will give the acquiring company good guidance for what the target's P/E multiple should be. 
• Enterprise-Value-to-Sales Ratio (EV/Sales) - With this ratio, the acquiring company makes an offer as a multiple of the revenues, again, while being aware of the PIE ratio of other companies in the industry. 

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