Six valuation traps

1. A one-off profit

Selling part of the business or revaluing an asset can make one year's profit much larger than usual, and then the P/E looks low. Read the income statement and look for items that will not come back. A current example is in the lesson on P/E ratios.

2. A peak profit

In mining, oil, steel and shipping the profit rises and falls with prices. When prices are high the profit is large and the P/E low, and that is often just when the profit is about to fall. So work from a profit over several years, not the best one.

3. The debt

P/E compares only the market cap with the profit. Two companies with the same P/E can carry very different amounts of debt, and shareholders stand last in line if things go wrong. So work out EV/EBIT as well, where the debt is included. The two can differ a lot: Eli Lilly has a P/E of 58.4 and an EV/EBIT of 41.8, and Oracle a P/E of 21.2 and an EV/EBIT of 21.7. Between operating profit and profit lie interest, tax and sometimes one-off items. How debt is measured is in the lesson on debt.

4. Different sectors

Multiples differ between sectors, because the companies grow at different speeds, tie up different amounts of money in the business and carry different risks. The middle EV/EBIT per sector among the largest US companies:

A lower number for a company in telecoms than for one in consumer goods therefore does not make one cheaper than the other. Compare within the sector, and with companies that are alike, as in lesson 2.

5. The terminal value

In a DCF most of the value often comes from years far ahead. In the example in lesson 3 the terminal value is 75% of the value, and a required return one point higher lowers the value by 13%. Try several assumptions and see how much the answer moves rather than trusting one number.

6. The currency

All 20 companies here report in dollars, like their share price, but many companies listed in the US do not: a share traded in dollars can report in euros or yen. Divide a dollar price by earnings per share in euros and the number is off by roughly the exchange rate. Convert to one currency first.