When to use EV/EBITDA or P/E Ratio
In business, making profits is not an easy task. You first got to make profits at an operational level, then you must cover the interest cost and then pay the taxes. Many of the businesses like digital, telecom and infrastructure take a long time to break-even, leave along making profits. For instance, most digital companies have been making losses in India for well over a decade. P/E ratio is not a relevant measure for such companies, then what do you use?
One option is sum of total parts (SOTP) but that is too complex. The other measure, other than P/E ratio, that can be easily understood is the EV/EBITDA ratio. Let us understand what EV/EBITDA is all about. It is the ratio of enterprise value to the EBITDA, as under.
- Enterprise Value (EV) is the amount you have to pay to acquire the company and can be effectively expressed as (Market cap + market value of debt – cash balance).
- EBITDA represents earnings of the company before interest, depreciation and taxes. It considers operating profits without even providing for capital replenishment.
The EV/EBITDA looks at the ratio of what you need to pay to acquire a company as a proportion of what the company’s core operations are earning.
Why P/E approach cannot be applied in most cases?
There are some limitations to using P/E as a valuation measure.
- P/E is an outcome of market perception. Normally, the EPS is a reality, but the P/E is the market perception that determines the price of the stock.
- P/E Ratio is not too meaningful standalone, unless combined with growth. Any future growth projection has a largely issue of individual bias.
- P/E looks at returns to equity providers. However, they are just one of the many stakeholders in the company. That is the limitation of using net profits.
- P/E can be slightly fluid for loss-making companies and cyclical companies. In such cases, it is tough to decide what to consider as a representative P/E ratio for the company.
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 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 market value of debt is tough to estimate amidst volatile interest rates; but it is still an amazing value addition.