Why do P/E multiples an EBITDA multiples yield different valuation results?
Stuck on this interview question that an interview asked me.
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A bunch of reasons, but the answer that the interviewer is probably looking for is "Leverage." P/E ignores leverage since it is an equity-based valuation, but EBITDA values the enterprise value. If you lever up a whole bunch to increase earnings, that doesn't actually increase the value of the company / asset, it just makes the earnings more volatile, indicating that the earnings should warrant a lower P/E multiple. So one should generally avoid P/E multiples since they are distorted by the effects of leverage and utilize an EBITDA multiple or some other multiple that gives enterprise value versus equity value.
Your first half is right, but if you went on to say that second half in an interview you would be dinged. That is just wrong.
Which part? (quote me). I said "generally" for a reason.
I'd say "capital structure" not "leverage" because an excess of cash on the balance sheet (especially in a low rate environment) is also going to cause PE and EBITDA valuations to diverge.
Your answer also kind of suggests that debt is free, but it creates interest expense, which of course depresses EPS, until/unless the company is converting the debt to earnings at a rate in excess of the debt's cost.
(All that said, I realize this was a WSO comment, not a PhD dissertation).
P/E => Equity Value/Net Income (therefore depends on capital structure, interest payments, etc)
whereas say, EV/EBITDA is capital structure independent and therefore will give different multiples
What the interviewer was probably getting at was why the EBITDA multiple range generated by a set of comps would yield a different valuation than would a PE multiple range generated by the same comps.
The answer? Because no two companies have the exact same capital structure or cost of capital, and companies convert different sources of capital to earnings and cashflow with varying degrees of efficiency. Which results in numerators and denominators in the two sets of multiples that are not proportional.
Direct answer: Capital Structure.
I got this and just prefaced my answer with "just thinking out loud here..." and actually verbalizing my thought process before getting to that.
I'd broadly think about what is the difference between EBITDA and Earnings (E), which could drive this difference? It's interest, taxes, depreciation & amortization, so:
1) Interest: Covered by others, capital structure
2) Tax Rates: Two firms may have different tax rates (different geography, REIT vs. C-Corp, etc.) so the same EBITDA would turn into different amounts of cash flows. A firm with a lower tax rate but the same P/E multiple would thus have a higher EV/EBITDA multiple.
3) Depreciation (Capital Intensity): If one firm uses a lot more capex, that could drive differentials as two firms with the same EBITDA would turn that into different amounts of cash flows. This would affect earnings by increasing depreciation. A firm with a higher capital intensity but the same P/E multiple would thus have a lower EV/EBITDA multiple.
4) Amortization: One firm may have a lot of amortization running through their earnings based on, for example, a big recent acquisition. This would impact earnings as well, so a firm with a bunch of amortization but the same P/E multiple would have a lower EV/EBITDA multiple. In practice most investors will add-back this amortization for valuation purposes so this is the least likely answer in real life.
How exactly does leverage cause EV to EBITDA and PE multiples to diverge.? Assume two companies with same EV/ EBITDA, would the company with a higher leverage have higher or lower PE ?
Let's say Firm A and Firm B both have $100MM in EBITDA and $1B EV for 10x multiples. Lets further assume that each firm's shares trade at $50.
If firm A has $500MM (10M shares out) in equity and $500 MM in net debt while firm B has all $1B (20M shares out.) in equity, then firm A will naturally have higher interest expenses but also twice the Earnings Per Share numbers due to only having half the amount of equity (assuming an equal number of shares out.)
Therefore, if both firms generate $20MM in Net Income (remember firm A has the interest exp and there is probably some tax differences somewhere) then Firm A will have earnings of 20/10 = $2.00/share while Firm B will have 20/20 = $1.00/share. From here Firm A will trade at $50/2.00 = 25x while Firm B will trade at $50/1.00 = 50x.
Of course in there end, I made a lot of assumptions and it really comes down to how productively the debt is put to use. Is it spent on projects above the cost of capital? If the firms end up with the exact same numbers for NI then I believe the above is right
(I hope this is right/answers your question)
If I’m interviewing you I would expect you to say “company with higher leverage has earnings that are more risky (higher hurdle as meed to pay interest first, and also outright bankruptcy risk), and therefore investors are willing to pay less for each unit of earnings. P/E is exactly that - price per unit of earnings”.
If you go with all the accounting you’ll lose the interviewer, unless she’s giving you assumptions to work the math
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