Both the P/E and EV/EBITDA ratios are used to evaluate valuation in stock analysis and to compare companies at the industry level. If a P/E ratio is low on the surface, a stock may be viewed as potentially undervalued.
In the case of the broader market context, however, it may be that the lower ratio is indicative of other risks or may imply that there is a limit to growth potential.
An EV/EBITDA ratio is an all-equity valuation metric whereby firms in highly leveraged sectors like telecommunications, a firm may be overleveraged and so pronounce its EBITDA for total capitalization. A P/E of 30 and EV/EBITDA of 15 in a tech company can be deemed expensive, yet warranted by the high growth forecast, relative to utility company compared to a utility company with lower ratios showing a steady if not slow annualized growth.
Evidently, from both aspects, these two ratios assist investors to appraise whether the stock is the right price with regard to the earnings and earnings before interest, taxes, depreciation, and amortization .
Initial Ratio Calculations
To effectively evaluate stocks using the P/E and EV/EBITDA parameters, it is critical to appropriately begin the analysis. The process can be initiated as follows. First, the P/E ratio should be calculated by dividing the share’s market price by its earnings delivered per stock .
If a particular company’s stock trades at $100 per share and its earnings are $5 per share, then its P/E ratio is 20. Notably, the metric shows the number of dollars investors acquiring that stock are willing to spend for each dollar of the organization’s earnings. The EV/EBITDA parameter should be determined by dividing a company’s enterprise value by its EBITDA value. Similarly, if a firm has an EV of $50 billion and its EBITDA is $5 billion, then it’s EV/EBITDA = 10.
One approach to understand the practical value of starting the evaluation of a firm with these two rates is to create a hypothetical company, let’s call it TechCo, and its stock costs are $150 with $10 earnings per stock . Consequently, its P/E ratio is 15. If it simultaneously has an EV of $300 billion and EBITDA of $30 billion, then its EV/EBITDA is also 10.
Thus, in this way, it is likely to calculate the degrees at the initiation point of the analysis to help investors understand how the market evaluates stocks relative to the performance levels concerning both earnings and operational profitability of the company.
Industry Comparisons
When evaluating stocks with P/E and EV/EBITDA ratios, comparing these metrics across industries is essential. This step will tell you how your company compares to peers and whether it’s priced attractively relative to the sector.
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Select a benchmark: At first, you need to find the average P/E and EV/EBITDA for the industry. Assume that the average P/E is 25 for tech, while the EV/EBITDA is around 11.
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Compare individual companies: This allows using the industry average as a benchmark to compare individual stocks. If TechCo has a P/E ratio of 20 and an EV/EBITDA of 9, both lower than the industry average, the company may be undervalued relative to its peers and could be a good buy.
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Go quantitative: Finally, analyze the spread of the ratios across the industry. If most companies trade at a P/E of 25, but one company has a P/E of 40, it’s important to find out why. Is it because it has a faster growth rate, for example, or a great new product, or too much excitement in the market?
There is a well-known quote by Peter Lynch: “Know what you own, and know why you own it.”Thus, it is important not only to know the numbers, but also to attempt to explain them. Why does tech company A have a P/E of 20, but tech company B 40? Is it because the latter has more room to grow, or better profit margins, for instance?
Analyzing Financial Health
Understanding the financial health of a company is more than just glancing at its stock price; it requires a closer look at their fundamental financial ratios like P/E and EV/EBITDA. Here’s a step-by-step primer on evaluating financial health using these ratios:
Review Historical Ratios: Start by knowing a company’s historical P/E and EV/EBITDA ratios. If these figures are high or increasing, the market is very bullish about its future potential and growth . If the figures are declining, the company is in financial distress, or there has a revaluation of the future of the company.
Assessing Profitability and Operational Efficiency: Use the EV/EBITDA ratio to determine the operational efficiency of the company. A lower EV/EBITDA from their peers in the industry would suggest the company is managing its operations more efficiently or that the company is undervalued. For example, if Company X has an industry benchmark EV/EBITDA of 12 and has an actual EV of 8, it suggests a higher operational efficiency or potential undervaluation.
Cross-Verify with the Other Ratios: Use the debt to equity ratios, return on equity , and free cash flow ratios in combination to reflect the true financial picture. For instance, a healthy P/E ratio must have a corresponding ROE and consistent FCF measures. Here is a detailed note on how to evaluate P/E ratio historically.
Benjamin Graham once famously said, “Investment is most intelligent when it is most businesslike.” This means treating your investment as you would your business – with a sound understanding of finance.
Evaluating Market Expectations
Evaluating market expectations through financial metrics like P/E and EV/EBITDA presumes understanding of their relation to investor sentiment and future company performance. Here is how to evaluate market expectations based on P/E and EV/EBITDA ratios:
Compare Current Ratio to Historical: Compare the company’s current P/E and EV/EBITDA to the average over the historical period. Any significant deviation from the mean may indicate changes in the market expectations. For example, if a company traded at a P/E of 15 during the last five years but has recently risen to 25 without the rise in earnings to support the change, investors may be expecting the company to grow or make significant positive changes.
Analyze the Sector: Once again, the whole sector’s average ratio can be influential on single-stock performance. If the whole tech sector is now trading at a higher P/E due to technological boon or change in the regulation, companies in the tech sector are also likely to trade at a higher P/E due to the increased market expectations.
Correlate with Economic Indicators: Many economic factors like interest rates, inflation, and GDP growth may affect the investors’ expectations and in turn the financial ratios. For instance, lower interest rates may cause all P/Es to rise because when returns on bonds are low, investors are ready to pay higher premiums for earnings. Warren Buffet said it best: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
Considering Ratio Drawbacks
P/E and EV/EBITDA ratios are both potent tools for evaluating company value. However, like any other tool, they have their limits, and understanding these limitations is essential to a comprehensive investment analysis. For both P/E and EV/EBITDA ratios, there are several potential issues.
For P/E ratio, the primary limitation is that it can be very susceptible to earnings manipulation. An occasionally legal way of “adjusting” earnings without touching the actual business is releasing certain reserves, which artificially improves the earnings and thus decreases the P/E ratio. This creates a danger of evaluating a company as cheaper than it actually is based on the reduced P/E. As for EV/EBITDA ratio, the major flaw is disregarding the age of the assets and the difference in the level of debt between companies. For example, two companies might have the same ratio, but one uses significantly older and more worn-out assets, necessitating higher maintenance costs while another is relatively young. Investors, therefore, would be mistaken in assuming that the two companies have similar value for comparison.
Regardless of these problems, both ratios are still useful for determining the value of companies. However, it is important to realize that the ratios might not be directly comparable, due to differences between industries and markets. For instance, tech companies usually have far higher P/E ratios because their high growth rates factor in, while utility companies have low ratios due to their slow but reliable growth. In the words of Charlie Munger, “All I want to know is where I am going to die so I’ll never go there.” Taking this advice means recognizing not just where these ratios can help with investments but where they might become a trap.
Combining Insights for Investment Decisions
To integrate the knowledge of P/E and EV/EBITDA into investments, it is necessary to analyze a range of factors related to a company’s value, industry parameters, and future potential. The following steps can be undertaken:
Cross-Analysis
First, compare the P/E or EV/EBITDA ratio of a company chronologically, access the changes. Then, compare the outcomes to industry averages. For example, if a company has a lower P/E compared to the peer group, the latter is neutral, whereas a higher EV/EBITDA implies overvaluation due to operational EBITDA without considering things like interest, taxes, depreciation, and amortization.
Contextual Evaluation
It is crucial to consider the parameters of the economy and the industry to analyze these ratios. For instance, an almost 190 P/E for Apple can be considered as barely reasonable in the tech industry but too high to accept it in the food manufacturing sector without a fear a bubble might arise.
Scenario Analysis
Use these figures to conduct the what-if analysis. Estimate what changes in the market or the economy and how they can impact the ratios, and secondly, the stock price accordingly. For example, analyze how an increase in the rates can affect EBITDA and, subsequently, explain how the EV/EBITDA for a company can change.
It is impossible to succeed without the willingness to take risks, as Peter Drucker once said, “Whenever you see a successful business, someone once made a courageous decision.” To make bold yet data-driven investments, investors need to analyze these and various other reports.
