EV/EBITDA vs P/E: Better for Debt Comparison?

Imagine you’re trying to compare the prices of two similar houses to see which one is a better deal. The Price to Earnings ratio, or P/E ratio, in the business world is like looking at the price of a house relative to the homeowner’s income after paying the mortgage and other household expenses. It’s a popular metric that tells you how much investors are willing to pay for each dollar of a company’s earnings per share. You calculate it by dividing the company’s stock price by its earnings per share. A high P/E ratio might suggest investors are optimistic about future earnings growth, or it could mean the stock is simply overvalued.

However, if you’re comparing two houses, and one homeowner has a much bigger mortgage than the other, just looking at the house price relative to their after-mortgage income might be misleading. The house with the lower price might seem like a better deal based on this income, but it could be burdened by a huge mortgage that significantly reduces the homeowner’s take-home pay. Similarly, the P/E ratio focuses on earnings after interest expenses, which are directly impacted by a company’s debt levels.

Debt acts like a financial lever. Companies can use debt to amplify their returns, but it also comes with interest payments. These interest payments reduce a company’s net income, which is the ‘E’ in the P/E ratio. Companies with high debt levels will naturally have lower net income compared to similar companies with less debt, even if their underlying operations are equally profitable. This difference in net income, driven by debt, can distort the P/E ratio and make it difficult to compare companies fairly, especially when their debt levels are significantly different.

This is where the Enterprise Value to EBITDA multiple, or EV/EBITDA multiple, comes into play. Think of Enterprise Value as the total cost to acquire the entire company, not just the equity. It includes the market value of equity, but also the value of debt, and subtracts cash because cash can be used to pay off debt. So, Enterprise Value represents the value of the entire business operation, regardless of how it’s financed.

EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation, and Amortization, is a measure of a company’s operating profitability. It’s like looking at the profit a house generates from rent before considering mortgage payments, property taxes, or wear and tear. EBITDA essentially strips out the effects of financing decisions, like debt, as well as accounting choices related to depreciation and amortization, and tax rates, which can vary from company to company and country to country.

The EV/EBITDA multiple, therefore, compares the total value of the company to its operating profitability before considering the impact of debt. This is crucial when comparing companies with different levels of debt. Because EBITDA is calculated before interest expense, it provides a clearer picture of a company’s core operational performance, independent of its capital structure.

Imagine comparing two pizza restaurants. Restaurant A has taken on a lot of debt to expand rapidly, while Restaurant B has grown more organically with less debt. If you look at their P/E ratios, Restaurant A might appear cheaper because its net income is reduced by significant interest payments. However, this lower P/E might be misleading and simply reflect its higher debt burden.

Now, if you use the EV/EBITDA multiple, you’re comparing the total value of each pizza restaurant to their operating profits before interest expenses. This metric focuses on how efficiently each restaurant generates profit from selling pizzas and running its operations, regardless of how they financed their growth. In this scenario, EV/EBITDA offers a more ‘apples to apples’ comparison of their underlying business performance, removing the distortion caused by different debt levels.

In conclusion, while the P/E ratio is a widely used and easily understood metric, it’s sensitive to differences in capital structure, particularly debt. The EV/EBITDA multiple provides a more robust comparison for companies with varying debt levels because it focuses on the total enterprise value relative to operating profitability before the effects of financing. It gives a clearer view of the core business performance and makes it easier to compare companies on a more level playing field, regardless of their debt decisions.