P/E Conundrum, Stocks and Bonds, Finance and Capital Markets

To present a potential inconsistency in the price-to-earnings ratio, Sal creates a scenario based on two entrepreneurs who each purchase a pizzeria with identical assets. The first pays the entire cost outright, while the second pays 10% and borrows on the rest. Sal outlines the finances for each company, reaching identical operating profits. Next, he incorporates taxes and interest payments (for the second owner) to calculate the net income and determine if the price-to-earnings ratio holds up. Sal uses the "superficial" market capitalization results to show that the P/E ratio breaks down when comparing different capital structures.