Why a company's P/E multiple is higher or lower than another company? Help pls!
So assuming two companies are in the same industry, has similar business and are of similar sizes. Company A has a higher P/E multiple than company B, why?
I understand that P/E multiples are not awfully meaningful when it comes to comparing companies and they are distorted by tax rates, capital structures and non-core business operations, and my answer to that question is company A has a lower Net income and has therefore either lower revenue or higher costs compared to company B, in other words lower after tax profitability I guess.
I am not sure if that's correct and if there's any other answers/insights? I am particularly looking for other answers/explanations. I just got started in corporate finance and certainly don't know too much about it. I'd greatly appreciate any guidance - thanks guys!
UP!
P/E multiples neutralize the need to look at total net income. What it means is that an investor is willing to pay more for a share of the net income (thus accepting a lower yield) for one company than the other.
This is a result of the fact that you are willing to pay the present value of future share price, so that in the limit that share prices approach infinity (not realistic, but for the sake of the argument assume there is a maximum price), you are willing to pay more, therefore accept less increase in value.
There can be several factors that lead to this: you have more confidence in the future of one company than the other; you believe one company will grow faster, and therefore realize profits sooner than the other; you believe that one company has a certain advantage that the other does not; you believe management will execute the plan better.
Additionally, and some on this forum will debate this to the end of the world, capital structure does play a part as well. This should not need an explanation.
Thank you - so a higher P/E multiple means you are willing to pay more for a share of the NI and accept a lower yield because of the several factors you mentioned in the third paragraph?
What about my explanation (higher multiple - lower profitability and lower NI and caused by either lower revenue or higher expenses), is that correct?
Thanks!
Well, some of what you say is correct.
You could have lower absolute Net Income, but that does not necessarily mean anything at all. Sometimes a company has higher P/E despite having lower NI than peers today, even as a % of total revenue. Sometimes this is a result of high spending today to increase that margin in the future, or grow revenue in the future.
Basically, if the companies are exactly the same, then it comes down to the market belief that one will provide a certain stream of cash flow in the future more than the other, and the associated risk accepted by the investors to achieve that positive return. If a company has a higher risk in the future, you will require a higher yield to be compensated for the scarce resource of your investment fund, thus lowering the multiple you would pay for the earnings.
Looking at NI, revenue and expenses alone may not tell you the entire story.
Ok thank you - so need to pay more attention to the qualitative factors as a whole.
What about seeing things from the perspective of tax rates, capital structures and non-core business operations?
I know P/E multiples are distorted by those 3 factors, does that mean that a higher P/E (lower NI) multiple translates to possible higher tax rates, less revenue/profits coming from non-core business operations and more debt thus more interest?
This area seems to be murky to me for months.
You're asking a lot without really realizing it. Which is ok, but it's just a lot to answer. For example there are several measures of EPS that you could use in the denominator in your P/E calculation, i.e.; Reported (GAAP) EPS, Cash EPS, diluted shares outstanding...etc.
I would spend more time researching the EPS portion of the ratio as that will probably help you resolve some of the distortions you're struggling with. At the end of the day there are a number of reasons why two similar companies have different P/E. Hope that helps.
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