Just about every "Macro Research Analyst/Strategist" out there looks at PE (Price to Earnings) multiples as the main metric to value both individual stocks as well as the broader market.
To be sure, this metric has some validity but it loses a lot of efficacy by the very components in it's calculation. The "E" is represented by "Earnings". Earnings are the "bottom line" on the Income Statement of a company's financial statements. Earnings come in two forms: 1) GAAP and 2) Adjusted or non-GAAP. (GAAP are Generally Accepted Accounting Principles). GAAP earnings are effectively "pure" earnings. Non-GAAP earnings are those that are "Adjusted" for such "one-time" events like legal costs, restructuring costs (layoffs), etc. All of these one-time costs are added back to GAAP Earnings to get to Adjusted/Non-GAAP earnings, which are obviously much bigger after these add-backs. Take Alcoa for example: They have been "adding back" about $1.2bln in "one-time restructuring costs" for years! And that is on Earnings of only $500m-$1bln that is apparently available to common shareholders. Its like a Ponzi Scheme...perpetual one-time "adjustments"
Now the next problem with PE multiples is that the "E" is actually EPS (Earnings per Share). So this can get rather manipulated as well as companies have been on a real run of buying back their own shares which decreases the denominator in our multiple thus making the multiple look higher, or even more expensive. The risk with a company buying back its own shares is obviously that they see no better use of their cash in their business either for acquisitions or for growth capital expenditures to grow the business for the long term. Remember, when we buy an individual stock, what we are really buying is a cash flow stream of earnings (and we need to value that correctly depending on the quality of that cash flow stream).
And the final problem with PE multiples as a valuation tool is the "P". The P in the numerator only takes into account the Price the stock is trading at. What about the Debt, which is part of the Capitalization of a company? It is not all just market capitalization (stock market price X number of shares outstanding). When valuing a business, we need to look a the entire capital structure of a company: Debt and Equity.
There is a better,way to value a business and this is the way businesses value each other , most certainly when they look at acquisitions. EV/Ebitda is Enterprise Value (market capitalization plus debt less cash)/Earnings before (add back) Interest Expense, Taxes and Depreciation and Amortization (and when we look at Earnings, we need be diligent in what was added back in before we even start the calculation). This is the most "pure" way of valuing a business as it encompasses the entire capital structure of the company - Debt and Equity are calculated in the EV. . Company A doesn't look at buying Company B and say" hey, they look cheap at a PE multiple of 15x, let's buy them". They do however look at EV/Ebitda multiples as a source of valuation. And so do banks when they extend credit through a facility - can you imagine a bank looking at just the market capitalization of a company...ie...the stock price, before lending credit to a company??
EV/Ebitda is, quite simply, the purest form of valuing a business. Think of the difference between PE multiples and EV/Ebitda multiples as "retail valuation" vs "professional valuation". Each company I do fundamental research on, I model out the EV/Ebitda multiple. Quite frankly, I do not model PE multiples at all...pretty much useless the way I see it.
Now, lets look at the EV/Ebitda multiples on the S&P500 (first chart) and the Russell 2000 (second chart):
Yikes! Look cheap to you? Not so much to me.