What Makes EV/EBITDA a Better Alternative than P/E? – answer from Zack. I therefore need to use EV/EBITDA to do valuation, and coupled with P/sales, and P/BV. And FCF and Earing growth rate.
From Zack,
While P/E is the most commonly used equity valuation ratio in the market, a more complicated valuation metric called EV/EBITDA is often viewed as a better alternative as it offers a clearer picture of a firm’s valuation and its earnings potential. EV/EBITDA determines the total value of a company while P/E just considers its equity portion.
Also called enterprise multiple, EV/EBITDA is essentially the enterprise value (EV) of a stock divided by its earnings before interest, taxes, depreciation and amortization (EBITDA). EV is the sum of a company’s market capitalization, its debt and preferred stock minus cash and cash equivalents. In a nutshell, it is the entire value of a company.
EBITDA, the other element of the ratio, gives the true picture of a firm’s profitability as it eliminates the impact of non-cash expenses like depreciation and amortization that reduce net earnings. It is also often used as a proxy for cash flows.
Typically, the lower the EV/EBITDA ratio, the more appealing it is. A low EV/EBITDA ratio could imply that a stock is undervalued.
However, unlike P/E ratio, EV/EBITDA takes debt on a company’s balance sheet into account. For this reason, EV/EBITDA is usually used to value possible acquisition targets, as it shows the amount of debt the acquirer has to assume. Stocks with low EV/EBITDA multiple could be seen as attractive takeover candidates.
Another limitation of P/E is that it can’t be used to value a loss-making entity. A firm’s earnings are also subject to accounting estimates and management manipulation. EV/EBITDA, in contrast, is hard to manipulate and can also be used to value companies that have negative net earnings but are positive on the EBITDA front.
EV/EBITDA is also a useful yardstick in assessing the value of companies with a debt-laden balance sheet as well as significant depreciation and amortization expenses. The ratio also allows the comparison of firms with different debt levels.
Then again, EV/EBITDA has its flaws too. It alone cannot conclusively determine a stock’s inherent potential and its future performance. The ratio varies across industries and is generally not appropriate while comparing stocks in different industries given their diverse capital expenditure requirements.
Thus, instead of solely banking on EV/EBITDA, you can club it with the other major ratios such as price-to-book (P/B), P/E and price-to-sales (P/S) to achieve the desired results.
