One of the common debates in the world of equity analysis is regarding the better valuation matrix. While some hold the P/E ratio as a better valuation metrics, for some it is the EV/EBITDA that is the better metrics for valuing companies. That brings us to the fundamental question on debate between EV / EBITDA vs P/E ratio. We first need to understand the pros and cons of EV / EBITDA. Above all, it needs to be remembered that these two ratios are not competitive but actually complementary to each other. It is also essential to know when to use P/E vs EV/EBITDA ratio so that a clear picture of the financial condition of the company emerges.
Understanding P/E ratio, first and foremost..
It is common to say that company X has a P/E ratio of 10 and so it is cheap but company Y has a P/E Ratio of 28 and so it is expensive. That may be a very simplistic argument, but essentially, P/E is created by market perception. Is P/E ratio the outcome or is it the input? While P/E ratio is calculated as Price/EPS, actually the market determines the P/E ratio to be attributed for a stock and the price is just the result of that. Why does the market give high P/Es for some stocks and low P/Es for other stocks. There are a variety of factors at play here. Firstly, companies with higher ROE will automatically get a higher P/E ratio as these companies are generating more return per unit of capital. Secondly, companies which are in high growth segments or which have disruptive potential also tend to get a better valuation in the market. Thirdly, companies with strong brands, very reputed managements or companies that follow the highest standards of corporate governance also get good valuations. That explains why Titan gets a P/E ratio that is superior to other jewellery companies. P/E ratio is a very useful benchmark for equity valuation.
But what about debt; that is also part of capital, so EV/EBITDA comes in..
The major drawback in the P/E ratio is that it only focuses on the equity component of the capital structure and ignores the debt component. Of course, indirectly the P/E ratio also factors the debt component because normally high debt companies get low P/E ratios. But a better way to directly factor debt into your capital structure is through the EV/EBITDA approach.
EV / EBITDA
= Enterprise Value / Earnings before interest, tax, depreciation, amortization
The question is how do you calculate Enterprise Value (EV) in the first place?
Enterprise Value = Market value of equity + Market value of Debt
- Cash on hand
We need to understand what the EV/EBITDA measure actually indicates. It basically measures what is the value of the company if you were to acquire it. When you buy the company, you pay the equity market cap + take over the debt and get the cash balance as a credit. Enterprise Value is the price you pay to acquire the company at the current juncture. Then what is EV/EBITDA?
EV/EBITDA captures the payback period of your investment in the company. When the EV/EBITDA is 5, it means that it takes approximately 5 years for you to recover the cost of acquiring the company through EBITDA.
Comparing the P/E Ratio versus the EV / EBITDA ratio..
- P/E ratio is a gauge of what the market is willing to pay for the stock for every rupee earned by it. As mentioned earlier, the P/E is the input and determines the price of the stock. EV/EBITDA, on the other hand, measures the payback period. It is the number of years that it takes for your investment in the company to be recovered in the form of EBITDA generated by the company
- P/E is a good measure for the equity value of the company. Since it considers the residual profit (EPS) as the denominator, it gives a better picture of equity valuation. EV/EBITDA is a better gauge of company valuation, especially when one is looking at mergers and acquisitions. EV/EBITDA takes a more holistic picture of the company and covers the equity and the debt components of the capital structure.
- P/E ratio works well for manufacturing companies and companies where the business model is matured. EV/EBITDA works better in case of service companies and where the gestation is too long. For example, capital intensive sectors like telecom and sunrise sectors like Fintech, Ecommerce can better use of EV/EBITDA as a measure of valuation.
- The thumb rule is that a company with lower EV/EBITDA is more attractive. The condition is that the debt should not be high-cost debt and the equity must be fairly valued in the market. Also the EBITDA margins should be predictable. The P/E ratio has to be linked to growth rate. A company with higher growth can justify higher P/E ratios.
- In both the cases, it is the trend and the benchmarking with the industry averages that really matters. As long as there is a margin of safety as compared to the industry benchmarks and the trend is flat to positive, then it is a good sign.
- From a practical point of view, P/E ratio is simpler and easier to calculate. The complexity with EV/EBITDA is that market value of debt can be difficult to estimate especially in a volatile interest rate environment.