Kenya: Understanding Ratios Key to Size Up Firms

Source from:  Business Daily (Nairobi) 8 November 2007 11/09/2007

"Buy Bamburi as opposed to buying Athi River Mining (ARM), it is trading at a Price to Earnings (P/E) Multiple of 26 compared to ARM's 32." Or "Buy British American Tobacco (BAT) which is trading at a P/E of 11 as opposed to Kenya Commercial Bank (KCB) which is trading at a P/E of 20." I am sure you have heard statements like these many times. Perhaps you have also heard someone saying that Kenyan companies are overvalued due to the high P/Es when compared to other companies in the region or abroad. P/E multiples are often misunderstood and misapplied in many cases. A company which has a low P/E multiple does not necessarily mean that it is cheap when compared to a company that has a high P/E multiple. Looking at Equity Bank's trailing P/E of 41 and comparing it with KCB's 20 makes it seem way overpriced but is that necessarily the case? P/E multiples takes a look at the past in terms of the growth in earnings, sales and profitability. It however, does not look at the difference in capital structures, the return on invested capital, the nature and prospects of the industry, the competitive position and individual prospects of the company. Normally, companies which have high P/E ratios show that investors think that the firm has good growth opportunities as opposed to those with low P/E. Growth is however, not the only driver as the return on invested capital is a critical component. Multiples can provide valuable insights about a company and its competition when used correctly but when misused can be very misleading. When doing a comparative analysis between companies, first compare companies that operate in the same industry. For example, we would not compare KCB and BAT since KCB is in the banking industry while BAT is in the tobacco industry. Although companies can be operating in the same industry, they have different expected growth rates and returns on invested capital. So secondly, compare companies that have a similar outlook in terms of the growth prospects and the return on invested capital. Third, multiples should be used with forecasts so as to make more sense. Whenever you are buying an asset, you are basically looking for future growth both in terms of the capital gains and revenue stream such as the dividend. Finally, capital structures have a big impact on the earnings. A blind comparison between two companies' earnings can mask the differences in the capital structures. A highly leveraged company will have lower earnings and therefore most likely a higher P/E ratio. Remember that interest charged on debt is tax deductible. Bamburi and ARM for example have very different capital structures. While ARM is highly geared, Bamburi is not. Multiples based on the Earnings Before Interest Taxes and Amortization (EBITDA) are thus considered superior because they are not influenced by the capital structure and one off gains and losses. Next time, before deciding that a company is undervalued based solely on the P/E ratios, try and understand why it is different from the company you are comparing it to. As much as possible, use forward looking multiples based on the EBITDA as opposed to Earnings. Enditem