Why is P/E usually higher than EV/EBITDA? I got this question during an interview and really struggled.
Already know that:
Market cap < EV
Net earnings < EBITDA
But still can't find a good way to explain why P/E > EV/EBITDA for most companies.
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Top answer from a previous thread on a similar matter basically boiled down to splitting it up like this:
EV > equity value
EBITDA > NI.
I didn’t really like that answer, saw another basically stating that since the return rate for equity investors is higher than that of debtholders, so P/E is generally higher. I’m following this thread and would love to hear more input.
I like the rate of return way to go about it but careful cos return on equity will be the reciprocal of P/E and assuming P/E is higher than EBITDA multiple, the equity yield (E/P) will then be lower.
I think that's the best way to start answering the question, but one needs to delve deeper. Just because EV>EqV and EBITDA>NI, doesn't mean EV/EBITDA is greater than P/E(which can also be represented as EqV/NI). For example, 10/5 would be less than 3/1 even if the numerator and denominator of the former are larger than the latter. We'd need to compare the relativity of the denominators and numerators. If NI was a smaller percentage of EBITDA than EqV is of EV, then P/E is higher since you'd have a smaller denominator which means a larger value. If NI is a higher percentage of EBITDA than EqV is of EV, then P/E would be lower since you'd have a larger relative denominator which means a smaller value. Since the former statement is more accurate, P/E tends to be higher. NI is a smaller % of EBITDA since you're taking out D&A, interest expense, and taxes. EqV tends to comprise most of EV, so it's usually a larger %.
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My take:
- EV includes equity and debt
- The equity value will continue to rise with higher EBITDA (assuming debt levels stay the same), but the debt value will eventually peak, because once debt is covered, it's covered.
- P/E only includes the equity part, and therefore will be a higher multiple than the blended debt+equity multiple.
The other way to look at it is that because EV/EBITDA represents debt+equity holders and P/E represents only equity holders, you're blending the required returns on one and not on the other, and generally, the blended required return would be lower.
I think you have it down:
Denominator:
Earnings in p/e ratio are net earnings. After you take out depreciation, amortization, and other line items, you'll be left with a much smaller denominator compared to EBITDA.
Numerator:
Additionally, EV encompasses market value and also takes out cash, so there can be a situation where if a company owns a lot of cash, the numerator will drive down the the EV/EBITDA, example Apple.
The interviewer is just trying to see if you understand those ratios well and if you can talk your way through those ratios. If you said any of those things you wrote in this thread, you answered it well.
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honestly i feel in the industry those with the best technicals are prospective candidates and maybe interns.... haven't used or thought of any of this shit since i joined lol
I think that's more of a reflection of how useless these interview questions are lmao.
hahahahaha true
In short because the EV yield is distorted by the ultimate freeloader in the history of mankind - the government. It generates 10-30% return on literally 0 monetary investment.
Proponents of the longer story will also tell you that it’s because EV/EBITDA is the ultimate lie invented by incompetent investment bankers because it’s distorted by addition of D&A, which is actually a proxy for capex and so should be considered an operating expense. If you compare EV/EBIT to normalised P/E ratios, EV/EBIT will easily be higher
EV = debt + equity.
EBITDA is always greater than NI because it is NI + I + T + D&A.
imagine a company with no debt so EV = Equity.
imagine this company has net income of 0 but high d&a (or high interest expense).
then, PE > EV/EBITDA
think about a company without net debt/ net cash, without D&A and without taxes and then add each of the items one by one back into it
Bc EBITDA isn’t a fully netted profitability metric whereas EPS is.
you might expect EV / (EBITDA - Capex) to be similar to P/E
EV/EBITDA, P/E - they all in theory show how many years it would take for each investor group represented to break-even on their investments via company's earnings if they invested at the current price. Debt investors/lenders ALWAYS have the highest claim on a company's cash flow/earnings. Therefore, it will take the shortest amount of time for lenders to recoup the amount that they invested/lent in a company. Let's say its 6 years since lot of senior debt limits are set at 6-7x EBITDA. Common shareholders get paid the last after all the other investor groups are paid. Therefore, the P/E multiple or the number of years needed to break-even would be the longest/highest among all investor groups. Let's say 20 years. EV/EBITDA is a blended metric that represents all investor groups, so the number should come somewhere in between the two (6 years & 20 years) and generally it will be lower than P/E.
P/E is the same as Equity value/Net income. So we need to compare that to EV/EBITDA. EV is usually greater than EqV and EBITDA is greater than Net income. We need to evaluate the net income to EBITDA ratio and Equity value to EV ratio then. Net income is a smaller percentage of EBITDA than EqV is of EV. Therefore, if P/E has a relatively smaller denominator compared to its numerator, that means P/E is greater. Remember smaller denominator means bigger value. The reason I'd say net income is a smaller percentage of EBITDA than EqV is of EV is think of all the expenses from EBITDA to net income. Taking out D&A, interest expense, and taxes. That reduces the net income significantly. Whereas Equity Value tends to be the largest portion of enterprise value. It's not always going to be this way, but I would say a majority of the time it is.
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