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2)      The P/E ratio (Price/Earnings ratio)

The two companies must be comparable in terms of both the industry they are operating within and their capital structure.

Indeed, since net income is impacted by the capital structure, i.e. by the financial gearing = Net Debt / Shareholder’s Equity, it wouldn’t make sense to compare two companies with different levels of debt: indeed, a company with a higher leverage will be likely to show a higher net income. However, let’s also remember that these higher profits will be associated with a higher risk exposure.

The P/E ratio is given by Market Value of Equity / Net Income (where the market value of equity is taken at the end of year n, and net income is for year n), where just like above the “market value” can be based on the observation of the company stock value (if the firm is listed) or on transaction prices. Note however that the numerator of this ratio is the Market Value of Equity (and not the enterprise value). The reason for this is that Net income represents the profits generated by the company after financial expenses (i.e. after the debtors have been paid); therefore, it should be compared with the value which is going to shareholders only, and this value is precisely the Market Value of Equity.

The P/E ratio represents how many times its annual earnings the company is worth.

Upon establishing a benchmark m* for the P/E ratio in the relevant industry and for the appropriate level of capital structure, the market value of equity for the target company X will be given by:

Market value of equity = m* x Earnings_X.