Using EV/EBITDA and Price-to-Earnings (P/E) Ratios to Assess a Company

The EV/EBITDA multiple and the price-to-earnings (P/E) ratio are used together to provide a fuller, more complete analysis of a company's financial health and prospects for future revenues and growth. Both ratios use a different approach when analyzing a company and offer different perspectives on its financial health.

The EV/EBITDA Ratio

EBITDA stands for earnings before interest, taxes, depreciation, and amortization. EBITDA is calculated before other factors, such as interest and taxes, are considered. It also excludes depreciation and amortization, which are non-cash expenses. Therefore, the metric can provide a clearer picture of the financial performance of a company. In some circumstances, it's used as an alternative to net income when evaluating a company's profitability.

The other component of the EV/EBITDA ratio is enterprise value (EV). This is the sum of a company's equity value or market capitalization plus its debt less cash. EV is typically used when evaluating a company for a potential buyout or takeover. The EV/EBITDA ratio is calculated by dividing EV by EBITDA to achieve an earnings multiple that is more comprehensive than the P/E ratio.

The EV/EBITDA ratio compares a company’s enterprise value to its earnings before interest, taxes, depreciation, and amortization. This metric is widely used as a valuation tool; it compares the company’s value, including debt and liabilities, to true cash earnings. Lower ratio values indicate that a company is undervalued.

Drawbacks of EV/EBITDA Ratio

However, the EV/EBITDA ratio has its drawbacks. The ratio does not include capital expenditures, which for some industries can be significant. As a result, it may produce a more favorable multiple by not including those expenditures. By not reflecting changes in capital structure, however, the ratio allows analysts and investors to make more accurate comparisons of companies with different capital structures.

EV/EBITDA is also exclusive of non-cash expenses such as amortization and depreciation. Investors are often less concerned with non-cash expenses and more focused on cash flow and available working capital.

The Price-to-Earnings (P/E) Ratio

The price-to-earnings (P/E) ratio is a ratio of market price per share to earnings per share (EPS). The P/E ratio is one of the most used and accepted valuation metrics and provides investors with a comparison of the current per-share price of a company to the amount the company earns per share. The P/E ratio is most useful when comparing only companies within the same industry or comparing companies against the general market.

Ultimately, this metric is ideal for helping investors understand exactly what the market is willing to pay for the company’s earnings. Thus, the P/E ratio represents the market's overall consensus on the company's future prospects. A low P/E ratio indicates that the market is expecting lower growth in a company and its industry or perhaps macroeconomic conditions that might be detrimental to the company. In this case, a stock with a low P/E ratio typically sells off because investors don't think the current price justifies the earnings estimate.

Drawbacks of Price-to-Earnings (P/E) Ratio

A high P/E ratio generally indicates the market expects share prices to continue to rise. When comparing companies, investors may favor those with a high P/E ratio over those with a low ratio. However, the ratio can also be misleading. High ratios may also be the result of overly optimistic projections and corresponding overpricing of shares. Also, earnings figures are easy to manipulate because the P/E ratio takes non-cash items into consideration.

Additionally, a low P/E ratio could mean a company is undervalued and represents an opportunity for the shrewd investor to buy while the price is low.

The Bottom Line

Successful stock analysts rarely look at just one metric to determine if a company is a good investment. As we've seen with the EV/EBITDA and P/E ratios, there are pros and cons to each metric. The numbers these ratios produce mean little without some interpretation and reflection on a variety of other factors that can affect a company's profitability and future performance. Used in conjunction, however, both metrics can give an investor a good starting point and some valuable insights as part of a comprehensive stock analysis.