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This pathway will walk us through the basics of banks, starting with some of the different types and their main functions, then starting to look at the regulation faced by the banks, both before and after the Global Financial Crisis.

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Greenwashing is the act of distributing false information about something being more environmentally friendly than it actually is.

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In this video, Max discusses the cost-of-living crisis currently enveloping the UK. He examines its impact on households as well as the overall economy.

CSR and Sustainability in Financial Services

In the first video of this two-part video series, Elisa introduces us to sustainability. She begins by looking at the difference between sustainability and corporate social responsibility, two terms that can be easily confused.

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Interpreting PE Ratios

Interpreting PE Ratios

Sarah Martin

30 years: Corporate Valuations

In the previous video on equity multiples, Sarah Martin introduced PE ratios. In this video she delves deeper into this topic and explains how to interpret PE ratios. She also expands on the adjustments that need to be made to arrive at an appropriate underlying valuation when using PE ratios.

In the previous video on equity multiples, Sarah Martin introduced PE ratios. In this video she delves deeper into this topic and explains how to interpret PE ratios. She also expands on the adjustments that need to be made to arrive at an appropriate underlying valuation when using PE ratios.

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Interpreting PE Ratios

8 mins 34 secs

Overview

PE ratios can be difficult to interpret. This is firstly because, the net profit metric used in PE ratios combines the operating performance and the capital structure. In addition to this, there are other distortions that can be caused due to a net cash position or due to quasi-debt items. It is important to understand this and keep this in mind when using PE ratios to arrive at meaningful equity valuations.

Key learning objectives:

  • Understand what a low PE ratio could mean

  • Understand what a high PE ratio could mean

  • Understand the adjustments that need to be made for net cash distortions

  • Understand the adjustments that need to bede for quasi-debt and non-core earnings

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Summary

What does a low PE ratio mean?

If the firm has a low PE ratio, typically means it is a firm with low or negative ROIC, low or negative growth and a higher WACC. It can also mean that the firm’s earnings are expected to fall in future. A low PE ratio does not always represent good value. Its earnings may be on a downward trend and its future PE is rising and becoming high

What does a high PE ratio mean?

A high PE ratio could mean that it is a good firm, with high growth, high ROIC and a reasonably low cost of capital. It could also mean that the firm’s net profit has fallen this year but that the market is expecting a recovery. A high PE ratio could also indicate that the firm has very high leverage and its net profit is low due to high interest charges, causing an bias in the PE ratio. 

How are PE ratio distortions caused by net cash positions?

PE ratios are based on net income and this metric is obviously calculated after finance income and finance expense. PE ratios can become distorted due to net cash, particularly if interest rates are low. Net cash means the firm has more cash and cash equivalents than total debt. 


How should you adjust the numbers for a firm whose PE ratio is distorted by net cash balances?

Deduct net cash from the market value of equity and deduct the after-tax interest income from the net profit and we will have the underlying PE ratio of the firm’s business operations. 


What are the adjustments to be made for quasi-debt whose cost is not reflected in net profit?


Equity valuation is based on net profit and therefore takes account of net debt via the interest charge. Many firms will have debt-like liabilities whose cost may not have been deducted to arrive at underlying net profit.

Imagine a firm with derivatives liabilities. For example, if a firm has derivatives liabilities that rise by 500 million dollars between the start and end of the financial year, this increase will be shown as an exceptional charge in the income statement and will be ignored from the multiple valuation. However, the equity valuation has fallen by 500 million dollars as equity investors now owe an extra 500 million dollars to the derivatives counterparty. So, we have to adjust the equity valuation up or down to reflect changes in quasi-debt liabilities such as derivatives, retirement benefit deficits and off-balance sheet liabilities.

What are the adjustments for non-core earnings?


If a firm has assets that are not operating assets, it is better to value these separately from the valuation of the underlying business. An example of this would be an industrial firm which has surplus property and is renting it out to receive rental income. Don’t value the rental income using the PE ratio of the industrial business. Exclude the after-tax rental income from the total net income and then you are just valuing the underlying business. Work out the value of the surplus property and then add this on to the value of the underlying business.

 

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Sarah Martin

Sarah Martin

Sarah Martin has a degree in economics from the London School of Economics and stock exchange and regulatory qualifications from London and New York. She has worked in investment banking for 17 years, as well as private equity transactions and as an expert witness in financial trials. She became a financial trainer 15 years ago and specialises in credit, distressed debt, and valuation. Recent assignments have included the European Central Bank, the European Investment Bank, the EBRD, Gibbs Business School in Johannesburg, the Bahrain Institute of Business Finance, the Bank of China, BBVA, the African Development Bank, Siemens, Carnegie Bank, Rand Merchant Bank, the Hamburg Central Bank, and Mizuho Bank.

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