The price-to-earnings (P/E) ratio is one of the most popular and widely used financial metrics, but it has a number of inherent flaws for which the enterprise value to EBITDA (EV/EBITDA) ratio compensates. Investors who understand how both ratios work and how to evaluate their results give themselves an advantage when trying to determine which stocks offer the best wealth-building opportunities.

Key Takeaways

  • The price-to-earnings (P/E) ratio is a popular valuation metric that indicates a company's future growth potential by comparing its current market price to its earnings per share (EPS).
  • Using the P/E ratio to evaluate a stock has its drawbacks, including the potential for management to manipulate the earnings portion of the metric and the potential for overly optimistic investors to run up the stock price, causing an inflated P/E ratio.
  • One advantage of the EV/EBITDA ratio is that it strips out debt costs, taxes, appreciation, and amortization, thereby providing a clearer picture of the company's financial performance.
  • One drawback of the EV/EBITDA ratio is that it can produce an overly favorable number because it doesn't include capital expenditures, which for some companies can be a huge expense.

Understanding How the P/E Ratio Works

The P/E ratio is a valuation metric that compares a company’s stock earnings per share (EPS) to its current market price. This metric is widely known and used as an indicator of a company's future growth potential. The P/E ratio does not reveal a full picture, and it is most useful when comparing only companies within the same industry or comparing companies against the general market.

A high P/E ratio typically means that the market is willing to pay a higher price relative to earnings because there is an expectation of future growth in the company. Tech stocks, for example, usually carry high P/E ratios. A low P/E ratio indicates that the market is expecting lower growth in the company or perhaps less favorable macroeconomic conditions that might hurt the company. As a result, despite its earnings, the stock typically sells off somewhat if it has a low P/E since investors don't think the current price justifies the earnings outlook.

P/E Ratio Shortfalls

There are problems that arise for investors with the use of the P/E ratio. The stock price can get run up if investors are overly optimistic causing an overvalued P/E ratio. Also, the earnings portion of the metric can be manipulated somewhat if, for example, a company's earnings are flat, but the company's management reduces their outstanding shares, thus boosting the company's earnings on a per share basis.

Advantages of Using the EV/EBITDA Multiple 

The EV/EBITDA ratio helps to allay some of the P/E ratio's downfalls and is a financial metric that measures the return a company makes on its capital investments. EBITDA stands for earnings before interest, taxes, depreciation, and amortization. In other words, EBITDA provides a clearer picture of the financial performance of a company since it strips out debt costs, taxes, and accounting measures like depreciation, which spreads the costs of fixed assets out for many years.

One of the most effective ways to use EV/EBITDA is in a comparison valuation where the metric is used to evaluate similar companies in the same industry.

The other component is enterprise value (EV) and is the sum of a company's equity value or market capitalization plus its debt less cash. EV is typically used in buyouts. The EV/EBITDA ratio is calculated by dividing EV by EBITDA to achieve an earnings multiple that is more comprehensive than the P/E ratio.

EV/EBITDA Flaws

However, the EV/EBITDA ratio has its drawbacks, such as the fact that it doesn't include capital expenditures, which for some industries can be significant. As a result, it may produce a more favorable multiple by not including those expenditures.

Though the calculation of this ratio can be complex, EV and EBITDA for publicly traded companies are widely available on most financial websites. The ratio is often preferred to other return metrics because it evens out differences in taxation, capital structure (debt), and asset counting.

P/E Ratio Versus EV/EBITDA

The P/E ratio has been established as a prime market valuation metric, and the sheer volume of current and historical data gives the metric weight in regard to stock analysis. Some analysts contend that using the EV/EBITDA ratio versus the P/E ratio as a valuation method produces better investment returns.

Both metrics have inherent advantages and disadvantages. As with any financial metric, it's important to consider several financial ratios including the P/E ratio and the EV/EBITDA ratio in determining whether a company is fairly valued, overvalued, or undervalued.