Asked question during an interview; Why P/E ratio is higher than EV/EBITDA?
Last week, I had an interview for an internship at an investment bank.
I got a question about "Why P/E ratio is usually higher than EV/EBITDA"
So I explained it at first numerically this way; things between EBITDA and Net income like D&A, Interest expense, etc. are bigger than Net debt between EV and EqV.
And to add more, I tried to explain it conceptually using the return period and expected return concepts.
But I got stuck because while the expected return on debt investment is lower than that of equity investment due to low risk, the expected return period is shorter for debt investors according to the comparison between EV/EBITDA multiple and P/E multiple.
So I tried to approach it with the reciprocal of numbers because I thought EBITDA compared to EV indicates the return on investment for the year. But as going into deeper, I found out that the result was counterintuitive because EV/EBITDA was lower than P/E, which means EBITDA compared to EV was higher than the return on equity investment.
In the end, I couldn't answer it clearly so after the interview I asked him for an explanation. But he was also embarrassed with the result of my approach and told me that he also needs time to think of a way to explain it.
I'd love to know which part of my approach was wrong, and if I get that question again, how should I answer it?
Thank you in advance and have a good day.
you can look at the denominators: EBITDA you are adding back D&A, interest, and taxes back to Net Income while Earnings Per Share is a fraction of Net Income, so the denominator for P/E should usually be smaller
for the numerator: EV is enterprise value and it is usually smaller since price per share is relative to market cap - the case in which enterprise value is smaller is if the company is distressed, so the numerator for P/E should usually be bigger
P/E often has a bigger numerator and smaller denominator - making it usually bigger than EV/EBITDA
a part that you might be stuck on is that P/E is on a per share basis while EV/EBITDA is for the whole firm
Hope that helps
Wouldn’t EV for a distressed firm be larger than market cap because the cash flows for equity holders is greatly reduced by the debt burden? Market cap + net debt = EV
Here is my thinking, intuitively and logically unlevered returns should be greater than levered returns and therefore taking the reciprocal of it the unlevered valuation metric should be higher than the levered valuation metric as you rightfully described.
However the reason why the logic above doesn't hold for EV / EBITDA is because of D&A - which in the absence of a C/F statement is an I/S proxy for Capex spend. Remember with UFCF calculations you would need to subtract Capex. Thus that is to say the logic would hold if you compare EV / EBIT to P / E but since EBITDA is pre-D&A the comparison is therefore not exactly apples-to-apples as while one is a unlevered/levered metric you are not capturing the proxy for Capex in both.Hope this makes sense.
I think many in this thread and also in your answer are overthinking this question. Simply have to go about it the numerical way.
Enterprise Value / EBITDA, Market Cap / Earnings
EBITDA is a larger denominator than earnings given EBITDA excludes the value of depreciation, interest, tax, etc. Therefore often times your P/E is greater than the value of your EBITDA multiple. I think trying it from an “expected returns” point of view is overthinking it, and the above should generally be a satisfactory answer for the interviewer.
I would add the P / E is a much more market-influenced multiple. P / E = equity value / net income. Equity value is usually, but not always, smaller than EV, whereas Net Income is virtually always smaller than EBITDA. Therefore, EV / EBITDA usually lower than P / E. Qualitatively, because EV / EBITDA is influenced by debt on the numerator which is usually close to book value and not influenced by market fluctuations as much compared to equity value, and because both EV / EBITDA and P / E factor in future growth expectations, but EV / EBITDA has that 'growth impact' more spread out over a larger base, if that makes sense.
What bank even asked this question - does not seem helpful at all and does not tell you much. I have never seen any analysis that compares P / E directly to EV / EBITDA, kind of a dumb question tbh
Good answer and agreed rarely see P/E analysis expect for merger model, which even then just seems like something that is always done, unless I’m way off and public markets really care about that, which I’d get. Usually analyzing EV EBITDA in space I’m in. Guessing question came from a guide, have actually seen it before in one
Agreed with your reasoning as an aside in what instance would equity value be greater EV?
Numerically you could have a massive net cash position which solves for an EV smaller than equity value, however equity value implicitly accounts for the cash, so the equity value can’t be worth less than the net cash position on hand unless the market assumes management is just going to piss away value.
Would love to hear your thoughts
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