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The P/E Ratio Is Antiquated. Here Is Something Better.

This article is the second in a series that explains how our stock screening strategy differs from all the basic offerings out there.

Last week, we took a look at enterprise value (EV) and illustrated how it is a far superior statistic than the traditional market capitalization for defining how expensive buying an entire company would be.

Today, we're going to put EV to work as part of a devious plan to replace that most venerable of stock screening statistics: the price-to-earnings, or P/E, ratio.

The Problems With The P/E Ratio

The P/E ratio is simple to calculate:

P/E ratio = Stock Price per share / Earnings per share

Or, alternatively (and equally):

P/E ratio = Market Capitalization / Net Income

To be fair, P/E is a nice shorthand for how expensive or cheap a stock is against its trailing 12-month earnings. Experienced investors can look at a P/E ratio number and quickly tell you that 35 times earnings is expensive, while 9 times earnings is quite cheap. Essentially, the market at large generally trades in a range between 15 and 20.

But there are some clear weaknesses with the P/E ratio.

Problem #1 we've already talked about: market capitalization is an inferior metric to enterprise value for expressing the true "price" of a company.

Problem #2: using net income as the earnings value can be misleading. Net income includes all kinds of extraneous factors apart from the core business, including taxes, discontinued operations, and non-cash events like goodwill impairment write-downs. Many of these are one-time in nature and should not affect the ongoing business. While many firms will report "pro-forma", or "non-GAAP", earnings numbers, the fact is that P/E ratios often don't account for those adjustments and as such can be misleading.

Problem #3: unless you know the rules of thumb above, P/E as a stand-alone value isn't very meaningful, and cannot be compared against alternative yield-based investments like a bond or CD.

Something Better: The Earnings Yield

Let's tackle all 3 of these problems and devise an alternative metric that serves the same purpose as the P/E ratio but is more meaningful and reliable.

For now, we'll call it Metric X.

Problem #1 with market cap is easy: we just replace it with enterprise value. Done!

Metric X = Enterprise Value / Net Income

Problem #2 is a bit trickier. We want to use a value for earnings that represents the ongoing business earnings of the company, without much of the financial and accounting gobbledygook. To do this, we can focus solely on operating earnings, or more specifically, earnings before interest and taxes, commonly abbreviated as EBIT. No interest, no taxes, no discontinued operations, no one-time write-downs, etc. - just the ongoing business, baby!

Metric X = Enterprise Value / EBIT

Problem #3 has a simple solution as well. If we just invert the P and E, the expressed value becomes a percentage of earnings to the price being paid. For example, if we have a price of $10 and and earnings of $1, the P/E ratio would be 10 (10/1). But if we flipped that, we get a percentage of (1/10) or 10%. Voila, the earnings yield! This gives us a rough comparison against alternative investments that are almost universally expressed in yield terms.

Metric X = Earnings Yield = EBIT / Enterprise Value

Illustrating The Value Of Earnings Yield

Now that we have earnings yield defined, let's show why it is a more valuable metric than P/E. Let's take two stocks, DeVry University (DV) and Level 3 Communications (LVLT). We'll do this comparison with financial values as of early March 2016, but the basic idea is timeless. Comparing them by P/E ratio:

DeVry (DV): P/E of 38.4

Level 3 (LVLT): P/E of 5.2

So these fit very well into our "expensive" (DV) and "cheap" (LVLT) buckets for P/E ratio. If we were using all the other thrown-together screeners out there, that is how these two stocks would look.

But when we look at earnings yield, the picture becomes quite different (subscribers can see the full calculations by clicking the links for the tickers above):

DeVry (DV): 193 / 1,101 = 17.5%

Level 3 (LVLT): 1,360 / 28,461 = 4.8%

Wow, big difference! These ratios put DeVry in the top 20% of cheapest stocks in the entire market, while Level 3 actually has an earnings yield *below* the market average range! The outcome is completely flip-flopped from P/E!

So what happened? Earnings yield is actually helping us in a couple ways here.

Let's start with DeVry. The P/E ratio is including about $135 million in non-recurring restructuring and asset impairment charges taken by the company in the past 12 months. These should (we hope) not recur going forward, so the EBIT calculation ignores them, crediting DeVry's ongoing business with much more earnings. Additionally, DeVry has no debt so its enterprise value is smaller than market cap. The stock is actually quite cheap - not expensive as indicated by P/E!

As for Level 3, the opposite is true. LVLT doesn't have any meaningful non-recurring expenses, but it has an enormous debt load of $11 billion, vs. under $400 million in cash. This causes its enterprise value to be $28.5 billion, a far cry from the market cap of $17.8 billion. The earnings yield denominator becomes much larger, and we get a stock that is not nearly as cheap as it looks!

Conclusion

By using earnings yield instead of P/E ratio, we've actually boiled a decent bit of equity analysis down into a single number! Contrary to what P/E tells us, it is DeVry and not Level 3 that is the "cheaper" of the two stocks - and by a far cry, too!

All of our screening tools at MagicDiligence use the earnings yield as one of our core valuation metrics. It is a much more meaningful and telling valuation statistic than the P/E ratio, and one you won't find in the basic stock screening offerings available across the web. Try our tools out today!

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