P/E Ratio vs EV/EBITDA

[Yeshiva]

Hi all,

After doing a lot of reading, I've come to the conclusion that EV/EBITDA is better than the P/E ratio for the following reasons:

• P/E Ratios are often subject to one off profits affecting earnings (tax related, for example). EV/EBITDA allows for more even comparisons
• EV/EBITDA takes into account a company's net debt levels, whereas a company with a low P/E might also have high debt (and therefore be more risky despite being cheap at first glance)
• It's easier to manipulate post-tax earnings than pre-tax earnings, so EBITDA is better than earnings
• Tax rates are different for some companies that operate overseas, so being able to compare earnings pre-tax is useful (particularly for comparing NZ to Australian companies)

but I am keen to hear the contrary view - can anyone give me some ideas why using P/E is best for analysing companies?

[Wolf]

I tend to agree that EV/EBITDA is a better metric to use in analysing companies.
However no individual metric/technique should be used in isolation.

The P/E ratio is good for analysing mature companies that have a demonstrated ability to consistently grow earnings.
When using a P/E ratio I use underlying net profit removing oneoffs and adjusting earnings. (Normalising tax rates etc).

One problem with EV/EBITDA is that it excludes depreciation and amortisation which is a very real cost.
By excluding this capital-intensive companies that require a large amount of capex look cheap.
But in reality the operating cashflow never reaches holders as it is neccessary to maintain the business.
The difference between a low EV/EBITDA and a high EV/EBITDA is often a reflection of different levels of capital intensity.
For a capital intensive business EV/EBIT would be more useful.

EV/EBITDA is also a poor metric for valuing finance companies.
When comparing companies across countries you may want to take into account the different tax and interest rates using by using a P/E.

Thats my own opinion and a quick summary.
Theres alot more to it, but I would be out of my depth trying to explain it.
In my view the best way to value a company is using free cash flow.

I'd reccomend the book: Investment Banking:Valuation, Leveraged Buyouts,and Mergers & Acquisitions by Joshua Rosenbaum & Joshua Pearl

You should be able to find a pdf online.