P/E or EV/EBITDA - Which is a better measure of valuation?

P/E is a suitable measure for valuing the equity of the company as it includes the residual profit (EPS) as the denominator. EV/EBITDA is an apt measure of valuation when one is looking at mergers and acquisitions.  

Valuation of companies involves different methods to determine if a particular company is undervalued or overvalued. The two most commonly used ratios are the P/E ratio and EV/EBITDA ratio.  

Before figuring out which is a better measure, let’s shed some light on how to interpret the ratios and what they mean.  

P/E ratio is calculated as share price/earnings per share, it measures the money that investors are willing to pay for every rupee a company earns. 

Limitations of PE ratio 

• Price to earnings compares the price of a share with that of earnings that are available to shareholders (EPS), so only the equity value of the company is considered whereas the debt component is ignored. Consequently, companies that normally have high debt get low P/E ratios.  
• The P/E ratio is influenced by the market perceptions because the price of a share is determined by the investors and therefore some companies are likely to get higher valuations as compared to others. Taking an example, companies that are placed in high growth sectors and bear disruptive potential may get a high valuation or companies that have good brand value and reputed management can be valued higher than peers.  
• Unless interpreted with reference to growth, P/E Ratio by itself does not convey much analysis. 

EV/EBITDA Ratio 

This ratio has is divided into components: EV and EBITDA. EV, or enterprise value, is the total value of a company that is to be paid in case of acquisition of the firm. 

In formula terms,  

Enterprise Value = Market value of equity + Market value of Debt – Cash on hand 

Let’s understand it with an example, say you want to buy a shop which is selling at Rs 10,00,000. The seller of the shop has taken a loan of Rs. 2,00,000 for the maintenance of the shop, which you would have to pay in case you acquire the shop. Also, the shop has Tijori which consists of Rs 3,00,000 cash, which you would get in case you buy the shop. So, the actual value or enterprise value of your acquisition would be  

Rs 10,00,000 + Rs 2,00,000 - Rs 3,00,000 = Rs 9,00,000.

On the other hand, there is EBITDA, which is also known as the operating profit. It is the earnings before interest cost, tax, depreciation and amortisation, and is displayed in the firm’s income statement. It can also be derived by adding depreciation, interest cost & tax to net earnings.  

EV/EBITDA can be interpreted as the payback period of your investments, say the EV of a company is Rs 2000 crore and EBITDA of a company is Rs 200 crore, it tells that the firm can repay its entire cost of acquisition to the buyer in 10 years.  

Which measure to go with? 

P/E is a suitable measure for valuing the equity of the company as it includes the residual profit (EPS) as the denominator. EV/EBITDA is an apt measure of valuation when one is looking at mergers and acquisitions.  

P/E ratio is a better measure while valuing companies in the industries having high growth and which are not capital intensive such as IT. 

EV/EBITDA is ideal for valuing companies that carry high debt in their balance sheets and have high gestation periods like companies in the telecommunication, cement and steel sector. 

EV/EBITDA is also a suitable measure when valuing companies that are incurring losses at net earnings level but are recording positive operating profits.