Will you get your money's worth?

• Author: Maxson, Mark J.
• Position: Business and stock valuations - Mergers & Acquisitions

If you need a refresher on the financial theory behind business and stock valuations, here's a look at what P/E ratios, discount rates and the cost of capital mean -- and how you should use them to make better buying decisions.

Price-to-earnings (P/E) ratios, discount rates and the weighted average cost of capital are valuation terms that often mystify rather than clarify concepts that are critical to users of business and security valuations. What are they? How are they similar? How are they different? And how can financial executives who are considering acquisition and divestiture opportunities, or even simply analyzing corporate performance and shareholder value, better use them?

THE P/E RATIO: A VALUABLE BENCHMARK

Over the last 20 years, the evolution of academic research, computer spreadsheets and capital markets has done much to advance the level of sophistication and supportability associated with the valuation process. Nevertheless, a time-tested resource, the P/E ratio, remains a valuable benchmark for estimating the fair market value of a business or security interest. Typically, you can estimate the value of a firm or corporate division's capital by using various earning multiples observed for similar public companies. To use market multiples meaningfully, however, involves much more than gathering market data and multiplying. While a relatively simple calculation, P/E multiples can be improperly used in the valuation process.

Generally, a P/E ratio refers to the price of a common stock divided by the net income per share generated by a business over a 12-month period. A common share, in a corporation that earned $2 per share of net income, is trading at a P/E of 10 when its market price is $20. This is the P/E found in most daily newspapers. While there are many types of P/E ratios that can be used for a variety of purposes, there are two basic market multiple categories: common equity and invested capital multiples.

Common equity multiples are calculated by dividing the stock price by various equity-specific earning levels. Equity earning levels such as net income, cash flow (net income plus depreciation and amortization) and equity book value represent funds available for distribution to common equity investors. When used in a valuation, net income, cash flow and book value multiples can provide indications of common equity value.

Invested capital multiples are calculated by dividing the market value of invested capital (i.e., interest-bearing debt and equity) by various invested capital-oriented earning levels. Invested capital earning levels such as earnings before interest and taxes ("EBIT"), revenues, and earnings before depreciation/amortization, interest and taxes ("EBDIT") represent funds available to both debt and common equity investors. Invested capital multiples provide indications of a firm's total capital value, from which debt is subtracted to obtain the value of equity.

There must be consistency in the computation of the numerator and denominator of the P/E ratio. Where the numerator measures the price of...