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The alternate P/E and standard P/E are related by the net profit margin or net income/sales. Perhaps it becomes a little clearer by looking at the alternate P/E that a higher P/S ratio could become more favorable if the profit margin is higher causing a resultant higher earnings yield. It is just a way of looking at the same thing. Sometimes it makes it clearer and other times, it is less clear.
If we attempt to deconstruct the P/E ratio a little further, we will learn that Price/Earnings (P/E) is also equal to Price/Book x (1/Return on Equity).
Target (TGT)
Current P/E: 11.7
P/B: 2.22
ROE: 18.90
or P/E = (2.22) x (1/18.90) or 11.7
This can also be converted to an earnings yield by ROE X (1/P/B) or
EY = (18.90) x (1/2.22) or 8.5%
This mathematical exercise is to demonstrate that the balance sheets, income statements and cash flow statements are all related in various ways and ultimately not that scary if you begin to deconstruct them a little.
Don’t be afraid to experiment. For instance, most value investors understand the value of low Price/Sales. GuruFocus always runs a daily list of historical low price/sale stocks for further research. But take the numbers further and carry out your own trials. Let me give a simple comparison between Johnson & Johnson (JNJ) and Pfizer (PFE).
Johnson & Johnson | Pfizer | |
Mkt Cap | 181105 | 166535 |
Revenue | 62129 | 67561 |
P/S | 2.91 | 2.46 |
Neither P/S is particularly great, but that isn’t the purpose of this comparison. At a glance, you might slightly favor the P/S of Pfizer over Johnson & Johnson. Why do so many investors use enterprise value rather than market cap? Typically, because it gives a truer number as to what someone might have to pay for the company because it considers the debt. So, if we add the enterprise value to our experiment we get:
EV 176704 216663
EV/S 2.84 3.21
And suddenly, Johnson & Johnson appears a little better. But take it another step. Value investors follow margins closely. Gross profit or gross margin is so very important because it is a great indicator of supremacy or dominance in the market place. Gross Profit is simply Revenue minus COGS or the cost of the goods sold. If we use gross profit and enterprise value, we get the following:
GP 43087 51895
EV/GP 4.10 4.18
Whereas, earlier, the glance of the P/S ratios may have given the edge to Pfizer, now considering debt and cost of goods sold, Johnson and Johnson now appears a better prospect (however slightly). The most important part of this is that the statements are no longer your enemy. They become fun when you play with the numbers and sometimes provide you with clearer direction.
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