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When to use P/E Vs EV/EBITDA in Stock Market

When you deal with any of the financial markets, like the stock market, for instance, the P/E ratio or the Price to Earnings ratio may come into the picture. It is one of the most widely used and famous metrics, financially speaking, but you may discover many flaws inherent in its operation. However, these flaws may be compensated when you use another metric, the EV/EBITDA ratio. If you grasp how both the ratios can work for you, you can assess their results and give yourself the advantage of choosing the stocks that give you real wealth-growth opportunities. In the stock markets, who doesn’t look for wealth building strategies? All investors get into trading and investing in the share markets to grow capital. These ratios can help investors do that and go into stock markets with some arsenal on their side. 

Which is better?

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 ratio 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..

You must first understand that the P/E ratio constitutes a valuation measure or metric. This compares any stock earnings on a per share basis of a company to its present price in the market. Therefore, the metric is indicative of any company’s growth in the future. This is a metric that accurately measures the potential of any company to reach its achievable targets in the future. However popular this metric may be, it does not cover the whole picture of a company’s success potential. It can be most useful to serve the purpose of comparing companies that exist in the same industry, or for a comparison of companies with the markets in general. 

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 the 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 management 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.

To put the explanation in simpler terms, companies with high P/E ratios are those like Tech companies for which the markets are prepared to pay a high price compared to earnings due to the expectation that the company will grow well in the future. For companies with a low P/E ratio, a decrease in preferable macroeconomic conditions may be factors that hurt such a company. The company’s earnings may be high, but P/E ratios will be low. 

But what about the market value of 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, amortisation

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 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.

The Shortfalls of P/E Ratios

Investors experience problems while using P/E ratios. In case investors are incredibly optimistic, the price of the stock gets run up. The P/E ratio is then overvalued. Additionally, the earnings part of the measure is able to be manipulated, in a manner of speaking if, for instance a company show’s flat earnings. However, the same company may have a management that reduces any shares that are outstanding. This can boost the earnings of a company on the basis of every share (per share). 

The EV/EBITDA ratio has advantages..

The EV/EBITDA multiple goes a long way in allaying some pitfalls exhibited by the P/E ratio. It is a metric that is used in finance, to evaluate the return that a company makes on capital investment. EBITDA is an acronym for earnings before interest, tax, depreciation, plus amortisation. Plainly put, EBITDA offers more clarity of a company’s financial prospects as it gets rid of taxes, costs of debt, and measures of accounting such as depreciation. These spread the cost of assets which are fixed over a span of a long period.


Related Articles: How and Why to avoid the P/E Ratio Trap | What are the 7 factors that drive the P/E ratio of stocks higher | What does a mutual fund's PE ratio mean? 


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