I would like to share my proprietary method for calculating Price to Earnings (PE) ratio. I’m happy to share this IP with you, you are free to use it as you wish or discard it.
The reason I created this method of calculating PE is because I wanted a metric that I could use to calculate how much value there was in a business. For me, a traditional PE calculation doesn’t consider the total amount of money that you could get for your investment because dividends are removed from the earnings calculation and it doesn’t consider how much equity (in cash and cash alternatives) that a company could use to pay out to it’s shareholders. This is my proprietary PE calculation:
(Market Capitalization – (cash + cash alternatives)) / NPATLewis Hurst
This equation effectively gives you the part of the business your buying divided by the amount of money you could potentially receive.
Why Remove Cash And Cash Alternatives From the MC?
If a company’s Market Capitalization (MC) is $100M and the company has $99M in the bank, if you bought the business you’d own the $99M in the bank. Effectively the business cost only $1M, which is why I think it’s a more reasonable value to use than the MC alone.
The equation doesn’t add debt to the MC because even though you inherit the debt when you buy a company, you could view the interest as an expense like any other, which is taken into consideration by the NPAT.
Why Divide By NPAT?
I like to divide by NPAT instead of Net Income – Dividends, because NPAT is the amount of money that could come out of the company and go straight into your pocket. It’s the reason to invest and the value that’s generated by the company, as I see it. I don’t use figures before tax because I don’t consider how much I can help the tax man as part of my investment rationale when building a case about whether an investment is worthwhile.
I suppose you could call this an APNPAT (Adjusted Price to NPAT) ratio, instead of a PE ratio. As usual, different companies have different structures, risks and growth rates, which effects what metrics you might consider using in your investment proposition. Another factor is obviously your exit strategy. I probably wouldn’t use such a metric for an investment where the exit strategy was a sale, a traditional PE would be better in this case. However, if I were buying for dividend growth, I find this metric better.
I’d love to hear your constructive feedback in the comments below, and also any of your own valuation calculations that you’d like to share.