Which factor has more influence on P/E ratio? the P? or the E?
Hi, guys.
I got a little confuse with the P/E ratio. I know that P/E ratio is capital structure dependent. But there are two explanation for this argument: 1: The EPS is after interests payments, so the company which has more debts would get lower EPS, therefore P/E ratio is capital structure dependent. 2: There are 2 companies, which have exactly same enterprise value, future growth exceptions, market shares, etc.... The one that financing by debts would has less share outstanding (thus lower equity value), and the other that financing by shares would has more share outstanding (higher equity value). This situation may make the company that financing by debts always has lower P/E ratio. therefore P/E ratio is capital structure dependent.
Which one is the true reason that make P/E ratio capital structure dependent?
Thank you for your help.
In your second example the answer depends on what the actual P/E ratio is. To allocate capital properly, the cost of capital must be considered. For example, a company with a high P/E is actually better off using equity to fund growth (see energy companies in the last 12 months) as this cost is much lower than the combined effect of increased interest payments and credit risk. If the company has a low P/E (implying a high cost of equity), then they are better off using debt. In summary, the company that demonstrates an inefficient use of capital will be punished.
The best way to think about P/E is equity value over earnings, rather than inject shares into both the numerator and denominator. Theoretically, if both companies have the same market value (regardless of shares), then the impact of interest would lower earnings, thus only impacting one side of the equation.
Thanks for your response, when equity value is same for two companies, it is true that more debts would decrease the earnings, thus would make the company that has more debts get higher P/E. ..
However, lets go through an example: Assume company A & B has exactly same earnings (50), company A has 100 equity value and 200 debts ( interests 20)；Company B has 200 equity value and 100 debts (interests 10). then P/E for A is 100/(50-20)=3.33， P/E for B is 200/(50-10)=5.. In the example above, when two company have the same enterprise value, the company financing by more debts has lower P/E..
Some the debts impact on P/E should be considered under either equity value is the same or the enterprise value is the same... is that right? And my question is that which situation is the explanation for 'P/E ratio is capital structure dependent'?
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