Why EV/EBITDA Is Better Than the P/E Ratio: A Smarter Metric for Valuation

When to use EV/EBITDA or P/E Ratio

In business, profitability is challenging, especially for sectors like digital, telecom, and infrastructure, which often take years to break even. Digital companies, in particular, have faced losses in India for over a decade, making traditional metrics like the P/E ratio less useful.

One alternative is the EV/EBITDA ratio, a more insightful measure of stock valuation. Enterprise Value (EV) is the total cost to acquire a company, calculated as Market Cap + Debt - Cash. EBITDA represents earnings before interest, taxes, and depreciation, reflecting core operational profit.

EV/EBITDA vs P/E ratio: Unlike the P/E ratio, which focuses on net profit, EV/EBITDA focuses on operational profitability and is less influenced by capital structure. This makes it one of the best valuation metrics for stocks, especially for companies with heavy capital investment or those not yet profitable.

The difference between EV/EBITDA and P/E lies in their focus: while P/E looks at profits after expenses, EV/EBITDA provides a clearer picture of a company's operational efficiency, excluding non-cash items like depreciation.

Using enterprise value in stock analysis allows investors to understand the true cost of acquiring a company relative to its core earnings, making EV/EBITDA a powerful tool in stock valuation techniques for growth-oriented sectors.

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Table of Contents

1. When to use EV/EBITDA or P/E Ratio
2. Why P/E approach not be applied in most cases?
3. EV/EBITDA can work where P/E does not work

Why P/E approach not be applied in most cases?

The P/E ratio has some key limitations as a valuation measure. Firstly, P/E reflects market perception, not just the company's fundamentals, since it's based on earnings per share (EPS) but influenced by market sentiment. While P/E can offer insights, it’s not meaningful in isolation and must be paired with growth projections, which are often influenced by individual bias.

Another limitation is that P/E only looks at returns to equity shareholders, ignoring other stakeholders like debt holders and employees. This narrow focus on net profits can be misleading. Additionally, P/E tends to be volatile for loss-making or cyclical companies, making it difficult to determine a representative ratio.
This is where the EV/EBITDA vs P/E ratio comparison becomes useful. 

Unlike P/E, EV/EBITDA offers a clearer picture of operational profitability, factoring in both equity and debt stakeholders, and is less impacted by market perception. The difference between EV/EBITDA and P/E lies in EV/EBITDA’s broader focus on enterprise value in stock analysis, making it one of the best valuation metrics for stocks, especially for companies in industries with unpredictable profits or high capital expenditures.

For accurate stock valuation techniques, EV/EBITDA is often preferred over P/E, as it focuses on the company’s ability to generate earnings from its core operations, independent of financing decisions and market sentiment.

EV/EBITDA can work where P/E does not work

That is the valuation gap that the EV/EBITDA fills in.

• EV/EBITDA, in simple terms, measures payback period of a company acquisition. Here you assume that the company has positive EBITDA; otherwise even this ratio is largely meaningless. EV / EBITDA measures number of years it takes to earn back the sum paid.
• P/E can work for a running business in a stable sector. However, P/E does not help in corporate finance decisions like expansions, diversifications, mergers and acquisitions. In such cases, EV/EBITDA is more meaningful, as it considers all stakeholders.
• 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 or e-commerce can better use EV/EBITDA as a valuation measure.
• In the case of cyclical industries like metals and capital goods, EV/EBITDA can be a better measure as leverage and profits are more vulnerable to business cycles and financial solvency. Under these circumstances, P/E ratio is hard to standardize and could even give absurd results during peaks and troughs of the cycle.

The one thing that works in favour of the P/E ratio is that it is simple to understand and to apply. It is also a lot more elegant since data is publicly available, and you do not need to pore over the financials of the company. One complexity with EV/EBITDA is that the market value of debt is tough to estimate amidst volatile interest rates; but it is still an amazing value addition.