Can anyone clarify why would you use one over the other? Advantages/Disadvantages? I know it's a recurring question asked in interviews and I just want to make sure I know it well.
Price to Earnings Multiple (P/E)
The price to earnings multiple is calculated one of two ways.
- Market Capitilization / Net Income
- Price per share / Earnings Per Share
This metric is relevant to equity investors. As explained by @werdwerd, a private equity associate:
Net income is the bottom line of the income statement. Always remember, in capital structure, equity holders are the LAST people to claim any income, or assets in the event of bankrupcy. P/E, EPS, or Market Cap / Net Income are all ratios that deal with only equity, since it's taking from the net income number, which is what equity holders receive.
Also - Net Income has already accounted for interest expense - which is paid out to debt holders.
At a higher level, this metric tells an investor how much you are paying for one dollar of earnings.
Example: If Amazon.com trades at a PE of 70x - that means that an investor is willing to pay $70 for every $1 of earnings.
Enterprise Value to EBITDA Multiple (EV/EBITDA)
Enterprise Value / EBITDA is a metric that looks at the companies wholistic worth relative to a proxy for cash flow that is available to all investors.
Enterprise Value is calcuated by Market Capitilization + Debt - Cash. This figure accounts for the entire capital structure - not just equity.
EBITDA is Earnings Before Interest Tax Depreciation and Amortization. Known as a proxy for free cash flow, EBITDA looks at the earnings generated through the operations of the business.
Put another way by user @werdwerd, a private equity associate:
Enterprise Value is a figure that takes into account the entire firm - remember, that's market cap PLUS debt (as well as some other stuff but forget about it for simplicity's sake). Similarly, EBITDA is an earnings number that ignores capital structure. It comes from the income statement, starting at EBIT, before you account for interest expense. That means it doesn't discriminate between equity holders or debt holders, also accounting for the entire firm.
Why should you use EV/EBITDA or P/E?
User @werdwerd, a private equity associate, explains that:
There aren't any "advantages or disadvantages" to using EV/EBITDA or P/E - they're just two different metrics that allow you to compare apples to apples, not apples to oranges.
However, there are times when each metric may be more appropriate.
Price / Earnings is often appropriate for growth oriented businesses as the "price" component accounts for the market's future expectations of earnings. One downside of using P/E is that Net Income can often be skewed based on one time expenses and non-operational expenses.
When comparing businesses in the same industry that have vastly different capital structures (ex. one company with very little debt and another company with a great amount of debt) looking at EV/EBITDA can be useful.
How is EBITDA capital structure neutral?
As noted above, EBITDA and therefore the EV/EBITDA multiple is consdiered to be capital structure neutral - meaning that you can compare two companies that have vastly different capital structures.
Let's examine this comps set:
- Comp A - Market Value of Equity $100 + Net Debt of $50 = EV of $150, EBITDA = $15, EV/EBITDA = 10x
- Comp B - Market Value of Equity $500 + Net Debt of $500 = EV of $1000, EBITDA = $400, EV/EBITDA = 2.5x
- Comp C - Market Value of Equity $200 + Net Debt $0 = EV of $200, EBITDA = $50, EV/EBITDA = 4x
These metrics are unaffected by how the company chooses to finance itself, how much interest expense it has, and how it chooses to depreciate its assets. The latter element can have a big impact if the business has a lot of CAPEX and depreciation. These multiples are focused on the total value of the business to all investors relative to the cash flows from the operations of the business. Therefore, without even looking at the amount of debt relative to equity, through the operations of the business - you can state that Comp B might be undervalued at 2.5x EBITDA relative to the average of 5.5x EBITDA valuation.
What are the limitations of using comps?
While comps allow us to look at the relative value of a business and determine a company's worth based off its peer set, sometimes a company does not have a relevant public peer set or has something unique about it that makes it difficult to compare the business. In these instances, you should turn to intrinsic valuation methods. To read about an intrinsic value method, review our guide to the discounted cash flows (DCF).
Preparing for investment banking interviews?
The WSO investment banking interview course is designed by countless professionals with real world experience, tailored to people aspiring to break into the industry. This guide will help you learn how to answer these questions and many, many more.
Investment Banking Interview Course
- 7,548 questions across 469 investment banks. Crowdsourced from over 500,000 members.
- Technical, behavioral, networking, case videos, templates. All included.
- Most comprehensive IB interview course in the world.