Subtitles section Play video Print subtitles In the price to earnings conundrum video we encountered a situation where two different entrepreneurs bought an identical asset, in this case it was a pizza parlor or a pizzeria, but they each financed it in a different way. This guy was a little bit more conservative. He paid for it outright. The entire asset was his equity. He had no debt. While this guy, he borrowed some money and he even had some non-operating assets. So he levered up. For every $1 he put in he borrowed $10 from the bank in order to buy more assets that he actually brought to the table. And we saw when you did their financial statements-- their revenue, cost of goods-- everything up to the operating profit line was the same. And that makes sense because, if you remember the first introduction to income statement video, operating profit is really indicative of what the operating assets are generating. So in this case it's what this purple area right here is generating. You could also consider that the enterprise. What the enterprise is generating. And everything below the operating line, everything below the operating profit line, is either coming from non-operating assets, that would the case of non-operating income. And the entrepreneur on the right had some of that. He had some of this non-operating income, $2,000 per year in that case. While this guy didn't have any. And then you have expenses associated with interest. Right? In this case this entrepreneur had 5% of $100,000, so $5,000 a year. And then when you have these differences in capital structure it changes what your net income is. And they have slightly different net income numbers. But what we saw is when we applied the same price to earnings ratio, and they had the same share counts-- I didn't change too many variables here I just really changed how they paid for the asset. But when you apply the same price to earnings ratio to both earning streams, to both companies, you got something that was reasonably unintuitive. And there's no trick here really. Because it's not crazy to assign the same price to earnings ratio. And if you try it out, if you grow this guy's revenue a little bit, if you actually grow both of their revenues by the same amount or both of their gross profits by the same amount or if you grow both of their operating profits by the same amount, you're actually going to see that this guy's earnings per share is growing faster. So given that someone might say, oh, because of the leverage maybe I'm willing to pay even a higher multiple. So it's not crazy to pay the same multiple for both of these guys. But we saw at the end of the last video, when you apply, let's say, a 10 multiple, or really any multiple to both of these earning streams, you get a situation that at first doesn't look crazy. OK, the market cap of this guy is $210,000 if you apply a 10 multiple to their earnings stream, while the market cap of this guy is $189,000 if you apply a 10 multiple to their earning stream. Right? 10 times 18.9 thousand is 189,000. 10 times 21 thousand is 210,000. But what was the conundrum, what really got us thinking, was how can this whole equity stream right here, or this equity, or this earnings stream be, worth 210 and this one be worth 189 when this guy only put $10,000 in initially and this guy put $100,000? He put in 10 times as much. And so when you're paying $210,000 for this asset, for this equity, you are essentially saying that this asset is worth $210,000. But if you're saying that this equity is worth $189,000, right, that's what the market cap is. It's the value of the equity. Then you're implicitly saying that this asset, that all of these assets are worth the value of this market capitalization plus this debt, right? So that's $289,000. And then if you wanted the value of this operating asset you would subtract out this much right here, the cash. So you got something like $279,000. So when you apply the same price to earnings to to these similar businesses you've actually got a situation where you're overpaying for this asset relative to this one, even though they're identical. So that left us with a question: what do we do? What can we use other than a price to earnings ratio? And that's what this video is for. So the short answer is, one, you do have to use something different. Price to earnings ratio is a good a quick way of comparing two companies relative to their growth or relative to an industry. But it does lose a lot of information relative to how the companies are capitalized. You saw in the last video that how you're capitalized, and when I say capitalized I mean how do you pay for your assets. If you have a lot of debt versus a lot of equity, what actually happens on the earnings line is very, very different. And so you lose all of that information. And so if you want to capture that information, when you look at the price of a stock you have to figure out what you're actually paying for the enterprise of the company, the enterprise value of the company. So when I talk about the enterprise, or the enterprise value, I'm talking about the operating assets. It gets a little bit more complicated if you're talking about a financial company like a bank or an insurance company. But if we're talking about a widget factory, the enterprise is essentially the assets. The enterprise value is the asset value of the assets that allow the company to do business. So whatever factories-- well, in this case it's a pizzeria, so the ovens, the building, the places, where people actually eat their food, and even the cash that's necessary to operate the business. The enterprise value shouldn't incorporate the cash that's surplus, that's not necessary to operate the business. So that begs the question, how do you calculate the enterprise value? So you could go backwards and you say, OK, for a given price how much am I paying for an enterprise value? So let's say that this stock-- let's say that Company A or this one, let's say the stock right now is trading at $20. So this is the current price that you could buy it at. So it's the asking price in the market is at $20. While this one is at, let's say it's at $10. It's at $10. So at first glance you might just do a quick price to earnings ratio. And you'll say, OK, for $20 I'm getting $2.10 earnings per year, assuming it's not growing or something. So my price to earnings is approximately, I don't know have my calculator in front of me, but $20 divided by $2.10 is going to be 9 point something, something. Right? While this guy, for $10, I am getting $1.89 of earnings per year. So what's 100 divided by 18? It's 5 or 6 times. It's going to be 5 point something. 6 times 18 is 60 plus -- Yeah it's going to be 5 point something, something. So when you superficially just look at this you're going to say, wow, this is a cheaper price to earnings ratio, maybe I should buy that. But what we saw in the last video is that price to earnings isn't a good relative valuation metric when two different companies are capitalized very differently. So what you want to do is instead back out what these prices imply about the enterprise value. So what does $20 imply about the enterprise value and what does $10 imply. And how do you do that? Well first you say what is the market cap? Market cap. So you take the price times the number of shares. If you remember, we had 10,000 shares. So in this case $20 times 10,000 shares implies a