The EV/EBITDA multiple and the price to earnings ratio (P/E ratio) are used together to provide a fuller, more complete analysis of a company's financial health and prospects for future revenues and growth. Both ratios use a different approach when analyzing a company and offer different perspectives on its financial health.
The EV/EBITDA Ratio
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. EBITDA is calculated before other factors are considered; therefore, the metric provides a clearer picture of the financial performance of a company. The costs of fixed assets are distributed over many years.
The other component of the EV/EBITDA ratio is enterprise value (EV). This 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.
The EV/EBITDA ratio compares a company’s enterprise value to its earnings before interest, taxes, depreciation, and amortization. This metric is widely used as a valuation tool; it compares the company’s value, including debt and liabilities, to true cash earnings. Lower ratio values indicate that a company is undervalued.
However, the EV/EBITDA ratio has its drawbacks. The ratio does not include capital expenditures, which for some industries can be significant. As a result, it may produce more favorable multiple by not including those expenditures. By not reflecting changes in capital structure, however, the ratio allows analysts and investors to make more accurate comparisons of companies with different capital structures.
EV/EBITDA is also exclusive of non-cash expenses such as amortization and depreciation. Investors are often less concerned with non-cash expenses and more focused on cash flow and available working capital.
The Price to Earnings (P/E) Ratio
The P/E ratio is a ratio of market price per share to earnings per share (EPS). The P/E ratio is one of the most used and accepted valuation metrics and provides investors with a comparison of the current per share price of a company to the amount the company earns per share. The P/E ratio is most useful when comparing only companies within the same industry or comparing companies against the general market.
Ultimately, this metric is ideal for helping investors understand exactly what the market is willing to pay for the company’s earnings. Thus, the P/E ratio represents the market's overall consensus on the company's future prospects. A low P/E ratio indicates that the market is expecting lower growth in a company and its industry or perhaps macroeconomic conditions that might be detrimental to the company. In this case, stock with a low P/E ratio typically sells off because investors don't think the current price justifies the earnings outlook.
A higher P/E ratio, on the other hand, indicates that the market expects share prices to continue to rise. Higher P/E ratios are not always positive, however. High ratios may be the result of overly optimistic projections and corresponding overpricing of shares. Also, earnings figures are easy to manipulate because this ratio takes non-cash items into consideration. Thus, it is often advisable to use this metric in conjunction with metrics such as EV/EBITDA to obtain a more complete and accurate assessment of a company.