PE versus EV/EBITDA

I thoroughly appreciated the cover story published in your previous issue. It was meticulous and lucidly highlighted the importance of looking beyond the PE ratio while also explaining the risks of giving excess emphasis to it. Can you shed some light on whether the EV/ EBITDA ratio is better than the PE ratio while conducting stock valuations?
- Soniya Agarwal

Editor Responds: Thank you for your encouraging words and positive feedback. The valuation of companies involves different methods to determine if a particular company is undervalued or overvalued. The two most commonly used ratios are PE and EV/EBITDA. Before figuring out which is a better measure, let’s shed some light on how to interpret the EV/EBITDA ratio. 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. EBITDA, which is also known as the operating profit, can also be derived by adding depreciation, interest cost and tax to net earnings. PE is a suitable measure for valuing the equity of a company as it includes the residual profit i.e. EPS as the denominator and EV/EBITDA is typically an apt measure of valuation when one is looking at mergers and acquisitions. The PE ratio is a better measure when valuing high growth and less capital-intensive business, such as companies in the IT sector. EV/EBITDA is ideal for valuing companies that carry high debt on their balance-sheets and have high gestation periods such as companies in the telecommunication, cement and steel sectors. EV/EBITDA is also a suitable measure when valuing companies that are incurring losses at net earnings level but are recording positive operating profits. Hope this helps. Keep writing to us.