Rest assured, this is not just another article on the importance of comparing companies in the same sector or of similar maturity. Whether to use the PER to compare Renault and Google does not make sense, to bring into competition Renault and Rivian isn’t much more interesting. We thus touch the finger on the first problem: finding comparables – same sector and similar stage of maturity.
Let’s take an example. With whom to compare Alphabet, whose activities are so diverse? Not a company even comes close to this tech giant.
So should we compare Alphabet’s PER with an average PER weighted by revenue or EBITDA by activity? Why not. Provided that we omit our first two criteria in addition to considering that there is no synergy or cost reduction between the group’s activities. Which is clearly not the case. All the more so when it comes to “modern” conglomerates specializing in a single major business sector.
In short, two important limits of the PER are already exposed above, but this is not the one we will talk about today. Without going into the limits specific to compensation policies – compensation by shares, stock options – or amortization, we will see why the price/earnings ratio is a dangerous comparative tool because of:interest tax shield” or “interest tax shield”.
The limitation of equity-value multiples like the Price-Earnings Ratio is that they are directly impacted by funding decisions, i.e. they can be distorted by differences in capital structure rather than through operational performance. Thus, for two companies with the same operational performance – turnover, margins, production costs – if one is entirely financed by equity, then it will show a much better net result than that financed by debt. However, this should in theory not change their valuation since the cost of debt and equity is identical regardless of the capital structure.
Let’s take an example to better understand:
Let’s compare a company’s bottom line with and without the payment of interest expense. We will use the following operating assumptions:
- Turnover = €50,000
- Cost of Goods Sold (COGS) = $10,000
- Operating Expenses (OpEx) = €5,000
- Loan interest from company A = €0
- Loan interest from company B = €5,000
- Effective tax rate = 25%
We then model the resulting income statements.
As we can see, company A records a higher net profit of €3,750 and not €5,000 as the amount of loan interest paid by company B. This difference of €1,250 comes from the fact that loan interest is an expense and therefore reduces the taxable amount.
Conversely, the financing of a company by equity does not appear in the income statement and therefore does not affect the PER.
A company’s arbitrary choice to finance itself through equity or debt should not impact the ratios we use to compare them since a company’s WACC is assumed to remain unchanged regardless of capital structure. The issue of new shares and dividends do not impact the income statement, unlike debt financing, which has a direct impact on the result. Since the PER does not take into account the impact of dilution – the share of profit that goes to shareholders – or the payment of dividends, debt financing therefore has a negative and unfair impact on this ratio.
To solve this major problem, there are two solutions. To do this, simply remove leverage from a company. That is to say, make the capital structures equivalent from one company to another and thus remove the effect of the “interest tax shield”. To do this, two solutions:
- Or use the EBIT after tax on the enterprise value.
- Either erase the effect of the interest tax shield.
- Use EBIT after enterprise value tax:
To counter this detrimental effect, it suffices to disregard loan interest. EBIT after tax for Earnings Before Interest and Taxes is a solution.
EBIT * (1 – Effective Tax Rate) / (Market Cap + Net Debt)
Personal suggestion, by using the theoretical tax and not the effective tax, you protect yourself from some errors of analysis caused by tax deferrals or exceptional disposals of assets.
On the other hand, if you use EBIT after tax, in other words an unleveraged cash flow measure, you should also use a capital structure-neutral measure of business valuation. This is why it is necessary to use enterprise value (EV) instead of market capitalization in the denominator.
- Clear the effect of the interest tax shield:
Simpler, you just need to settle the unfairness arising from the difference in the capital structure of the company. To achieve this, it will first be necessary to add the loan interest to the result and then remove the effect of the interest tax shield. Example :
Interest tax shield = Interest expense * Tax rate
Company A has no debt, so there is no need to calculate the amount of its tax shield. On the other hand, our company B has debt and loan interest, so:
- Interest tax shield amount = 5,000 x 0.25 = 1,250
- Net income + Loan interest – Amount of interest tax shield = 22,500 + 5,000 – 1,250 = 26,250
Note that the above formula only applies to businesses that are already profitable in terms of taxable income. This is not a problem in the context of the PER since it also requires a positive net result and therefore a result also greater than zero.
Admittedly, your comparative studies will take a little longer, but you will no longer fall into the basic traps of an analysis by valuation multiples.
Next article: Stock-Based Compensation – Consequence on company valuation