Most of the times we give a lot of importance to plain P/E while comparing two companies. For example, if I asked you to choose a company in the same sector with the following data.
(i) XYZ Company [Price=100, EPS=20, P/E=5]
(ii) ABC Company [Price=400, EPS=25, P/E=16]
95% of the people will go with XYZ to invest as it looks quite cheap in comparison to ABC. However, if I tell you that after 3 years the people who invested in XYZ have lost even their pants then what would be your reaction? Probably be, how on earth that is possible?
This is quite possible because while taking the investment decision on the plain P/E we are nowhere considering one of the most important factors in the business i.e. Debt. The XYZ Company though looks quite cheap but it was debt-laden and going forward as performance deteriorate the debt burden climbs up and the company fails to cope and busted.
So how one should take into account the debt of the company as well while calculating or comparing two companies?
The answer is to the use of “Adjusted P/E” in place of “Plain or Vanilla P/E”. Considering the above companies again for comparison with debt as well:
(i) XYZ Company [Price=100, EPS=20, M.Cap=30 Cr, Debt=200 Cr, Cash=10 Cr, Shares=1 Cr]
(ii) ABC Company [Price=400, EPS=25, M.Cap=100 Cr, Debt=60 Cr, Cash=30 Cr, Shares= 1 Cr]
Let us calculate above companies with Adjusted P/E to feel the difference.
Adjusted Price = Enterprise Value/ no. of Outstanding Shares
Adjusted P/E= Adjusted Price/ EPS
XYZ Company “Adjusted Price” = 220
XYZ Company “Adjusted P/E” = 11
ABC Company “Adjusted Price” = 130
ABC Company “Adjusted P/E” = 5.2
So as you can see due to a very high debt of XYZ Company, it is 1.11x times more costly as compared to ABC after adjusting “debt and Cash”.
Therefore while comparing two companies in the same business always go with “Adjusted P/E” instead of Plain “P/E” as it gives a more clear picture of the company.