By Abbas Fazalbhoy
Angels and VCs usually look at financial ratios such as (EV/ Revenue) – Enterprise Value multiple of Net Sales to evaluate the feasibility of an investment. But, “selling a lot and making no money is easy; any one can do it”, says Duncan Bannatyne, Dragon on Dragons’ Den, UK. Thus, Enterprise Value/ EBITDA (earnings) better explains the financial health of a company. The earnings are important and that’s what you take to the bank. Bottom line matters more than top line!
When trading securities, Price/ Earning (P/E) ratio is used instead of EV/ EBITA because Enterprise Value is a combination of debt and equity, while P/E is the equity-only cost of earnings. To explain, a firm worth $100 with earnings of $20 and a Debt: Equity ratio of 1:1, uses $50 of equity to generate $20 in earnings. The remaining $50 is debt. When you buy “stocks”, you are buying the equity of the company, not its debt.
Although the reciprocal of P/E is the “bang for your buck” analysis for the security, P/E does not account for growth in the company because it uses only earnings (historic or forecasted) and matches it to price. This “multiple” makes high-growth companies seem overvalued by not accounting for growth. The solution – PEG – price/ earnings to growth ratio, matches the P/E by the expected growth rates. Thus, a fairly valued company will have PEG = 1. A lower PEG is better and indicates the stock is cheaper; while a higher ratio is worse because the stock is more expensive.
(Source: NASDAQ.com – The Wall Street Bull)
But, investing in companies and equity is about evaluating the unknowns and assuming risk. What is the expected growth rate? What is the perceived risk? What are the future prospects of the company? – These are just some of the n number of questions that need to be answered. Each of us has our opinion, and to reiterate our opinions, there are ratios. Here is some anecdotal information on PEG’s –
PEG Ratios based on expected earnings for twelve months ending May 2012 –
Apple Inc. (AAPL) – 0.728
Google (GOOG) – 0.587
Abbas Fazalbhoy is currently pursuing his MBA at McMaster University majoring in Strategic Business Valuation. He has held several management positions in the IT arena and has worked closely with software development. Abbas currently works as Business Analyst at the RIC Centre.