One of the common ways to gauge the value of any stock is to apply various pricing metrics to them with two popular ones being the price-to-earnings and the EV to EBITDA ratio. While both may seem fairly similar on the surface, there are still distinct characteristics that make them differ from each other.
In the following, we will try to clarify these differences and examine each ratio regarding its purpose and usefulness in order to evaluate why some investors and analysts prefer one over the other.
What’s EV/EBITDA?
The EV/EBITDA ratio puts the enterprise value of a company in relation to its earnings before interest costs, tax payments, and depreciation/amortization charges.
The formula for EV/EBITDA is pretty straightforward:
Enterprise value is computed by adding a company’s debt to its current market capitalization and netting out any cash & cash equivalents. There are several ways to arrive at a company’s EBITDA, with the most common one starting at the firm’s net income and adding back taxes, interest payments, and any non-cash charges such as depreciation/amortization.
What’s the P/E Ratio?
The P/E ratio is very similar to EV/EBITDA in the regard that it depicts a company’s value in the numerator in comparison to an earnings metric in the denominator. Only this time, both components look at value and earnings from a different perspective:
The market capitalization of a firm is defined as the current stock price multiplied by the number of shares outstanding, whereas net income represents the accounting earnings attributable to the company’s shareholders which can always be found on the bottom-line of a company’s income statement.
The Difference Between EV/EBITDA and P/E
The fundamental difference behind both ratios is that each assesses a company’s value from two different perspectives:
While the price-to-earnings ratio only takes the market value of a firm’s equity into account and puts that in relation to net income (equity earnings), the EV/EBITDA ratio considers a company’s whole capital structure (both equity and lender claims) relative to the cash earnings generated by the firm’s core operations.
Aside from the EV/EBITDA and P/E ratio, there is a wide range of other valuation metrics which all share one thing in common: They try to gauge a company’s value relative to a standardized performance measure.
In our case, both EV/EBITDA and P/E assess the cost of acquiring a company in a certain way (enterprise value or market value) relative to its earnings whether it’s prior to interest, taxes, and non-cash charges (EBITDA), or after accounting for all those charges (net income). Let’s start by comparing the numerator of each metric.
Market Value vs Enterprise Value
The term market value itself is very generic and used in a variety of different circumstances. In our case, we refer to the market capitalization of a company which essentially reflects how much value the market is currently attaching to the company’s equity portion. Because of that, people also refer to it as the market value of equity.
We try to emphasize the term equity since it only represents the residual claims of a firm’s cash flows to the equity investors but not the creditors/lenders of the company. This distinguishment is important to be made in order to understand the difference between price/market value and enterprise value.
Needless to say, if a company wants to raise capital, it can simply borrow money as a second option aside from issuing equity. In essence, debt represents contractual commitments that a firm has to make in form of interest payments to lenders. It usually comes with certain tax benefits which makes it the better alternative to raising equity in particular circumstances.
So if within a company, both creditors have a certain amount of debt claims, and shareholders have another portion of equity claims, we would need to sum up these two amounts (by adding the market value of debt to the market value of equity) in order to account for a firm’s total value.
The last step would be to subtract out cash & cash equivalents to arrive at what’s known as a firm’s enterprise value. Since the enterprise value is supposed to represent a more practical cost of acquiring the whole company, we would net out the cash within the equation because we would be able to use the company’s cash balance to pay down a certain amount of its debt.
In summary, enterprise value reflects the total value of a company (debt + equity) while accounting for cash while market value/equity value only represents the value within a business that is attributable to its shareholders.
Earnings/Net Income vs EBITDA
Both net income and EBITDA represent a company’s income from operations at different stages within the income statement. While net income is often referred to as the bottom line because it accounts for all accounting expenses within the company, EBITDA mostly represents a company’s operational earnings before netting out interest and tax charges.
In addition to that, EBITDA is often used as a cash flow substitute because it adds back non-cash charges such as depreciation & amortization.
Just like enterprise value vs market value, we can also differentiate net income from EBITDA based on the fact that EBITDA is an earnings measure attributable to the whole firm (equity and debt investors) while net income represents earnings that are solely available to the shareholders.
EV/EBITDA vs P/E: Which One Is Better?
One considerable advantage of EV/EBITDA over P/E is that it can be used to compare companies with different capital structures.
A company’s capital structure is the combination of debt and equity that the business uses in order to finance its operations. Since EV/EBITDA looks at the whole capital structure of any given firm, it doesn’t matter if the companies that are compared with each other are financed in different ways.
For example, let’s suppose that there is company A with a mix of 50% debt and 50% equity that is financed differently than company B with a capital structure of 70% equity and 30% debt. Since the P/E ratio only takes the equity portion of a firm into consideration, it would be more difficult to allow for a fair comparison between these companies: Company B’s P/E ratio would rely more heavily on market perception, even if both companies had similar prospects and earnings levels.
The EV/EBITDA metric for both companies would not only be unaffected by any change in their capital mix, but also by any consequences from capital expenditures (depreciation & amortization) and debt decisions (interest payments). This is why some investors regard EV/EBITDA as a more neutral pricing metric in valuation.
Conclusion
Both P/E and EV/EBITDA are commonly used by investors and analysts to assess and display a company’s valuation standpoint in a quick and understandable manner. While the P/E ratio puts a company’s market equity into perspective to the shareholder’s net income, the EV/EBITDA addresses a firm’s total value relative to an arguably more useful earnings metric, which can provide a better picture in at least some circumstances.
With that being said, even if there is a far superior pricing metric than the ones mentioned above, it would still not be able to substitute a proper valuation process that involves measurable and quantitative assessments of a company’s risk profile, its capability to produce cash flows, and explicit assumptions regarding its future prospects.
