One common topic in accounting is financial ratio analysis. There are three main types of financial ratios: valuation, profitability and leverage, each measuring a different metric. The financial media references ratios often, most commonly P/E (price to earnings) ratios, which are valuation ratios. As we’ll demonstrate, this ratio has limitations and should be viewed in proper context. Here are a couple alternatives that might be useful during your financial analysis.

P/E Ratio and Alternatives

The P/E ratio is used to determine the value of an asset. The asset can be an individual stock or ‘the market’ as a whole. This rudimentary multiple essentially shows how much you are paying for a stock (or market index) based on its earnings. As an example, let’s say the stock market is quoted in the financial news as having a P/E ratio of 12 (a.k.a. ‘12 times earnings’). If the market index is trading at 1000 and the companies in the index have cumulative earnings of $83 per share, the P/E multiple would be roughly 12 times ($1000/83 = 12.04). Historically, broad stock market P/E ratios of 15 and under indicate the stock market is relatively cheap, P/E ratios of 16-17 are fairly valued, while P/E ratios 18 and are considered expensive or rich. The average P/E for the stock market since the 1870’s is 16.7 times.1

But beware which earnings number you’re using, because variations can reveal a much different picture. Financial commentators on network TV often mention the market is cheap, or at least fairly valued. But there are a few problems when relying on standard P/E ratios when making investment decisions. P/E ratios are often quoted as ‘pro forma’ which use forward looking numbers. So the ‘E’ is actually next year’s estimated earnings per share, which are almost always believed to be higher than current earnings, making the P/E ratio suspiciously low.

Near market tops, earnings estimates get overly optimistic. But earnings can disappear very quickly. In 2007, S&P 500 forward earnings estimates (for 2008) were well over $100 per share. That resulted in around a 15 P/E multiple, historically on the cheaper side. Then the financial crisis hit and 2008’s fourth quarter actual earnings disappeared-companies reported an aggregate loss of $23.25 per share, the first loss in history.2

Today, when looking at trailing earnings, or earnings that have actually happened, we see the market is actually trading at a much richer valuation than rosy commentators believe. Last twelve months (LTM) trailing numbers, the S&P 500 companies earned $87 per share in the aggregate, using generally accepted accounting principles or GAAP from the just reported first quarter.3 Using the more conservative reported earnings actually shows the market is trading at 24 times (S&P 500 index, 2090 divided by $87= 24), which is historically quite high.

Buying stocks with low P/E’s can become ‘value traps’, or a company that appears cheap via the P/E ratio but, after you buy the stock, never really increases in value to get back to an appropriate valuation level. It’s referred to as dead money because the stock is “cheap” for a reason, usually because it’s a mature company with low, or even negative, growth rates.

Two alternatives to the classic P/E ratio are the CAPE and EV/EBITDA. The CAPE ratio is the ‘Cyclically Adjusted Price Earnings’ ratio, created by Nobel laureate Robert Schiller of Yale University. It adjusts the standard P/E ratio for natural business or economic cycles, roughly every ten years. So it takes the ten-year average of actual earnings for S&P 500 companies.5 This smooths out earnings and keeps optimistic estimates by analysts, driven by optimistic guidance from company management, in check. It can reveal a market that is actually more expensive and therefor dangerous for an investor. Financial advisors should have at least an undhttp://marketerstanding of these ratios to manage risk for their clients.

Another alternative is the EV/EBITDA ratio, which is more geared towards valuing individual stocks rather than market indexes. The numerator is enterprise value which looks at the cash flow generating ability of whole company, both equity and debt components.6 The denominator, EBITDA, also known as operating income, is a cleaner representation of earnings than EPS because it takes out the effects of amortization and depreciation on the bottom line.7 In other words, it adjusts for some accounting shenanigans. It’s also cleaner because it can’t be artificially increased by share repurchases by the company. By reducing the outstanding share count, EPS goes up (all else equal), which brings the traditional P/E ratio down.

Online Masters in Accountancy Degree

If you are interested in dissecting numbers like the ratios above, you might consider becoming a financial analyst or accountant as a financial career option. Pursuing an online Masters of Accountancy (MAcc) degree helps prepare candidates to sit for the prestigious Certified Public Accountant (CPA) exam. Another program that focuses heavily on ratio analysis is the Chartered Financial Analyst (CFA) program, especially levels I and II.

Whatever area of business (sales, marketing, finance, compliance, etc.), it helps to be well-versed in financial jargon. Knowing the ins and outs of various financial ratios may help you pass challenging exams, look sharper in an interview, or make smarter investment decisions during your career in finance.