EV/EBITDA vs. P/E: Which is the Better Metric for Stock Analysis

Investing in the stock market is as much about strategy as it is about numbers. It often seems as if you are being asked to decipher a language written in ratios. Among many formulas, the two most common ratios are Price-to-Earnings ratio (P/E) and Enterprise Value-to-EBITDA ratio (EV/EBITDA). Both are important factors to use when it comes to evaluating a company’s valuation and serve different purposes in different situations.

If you have ever wondered when to use P/E and when to rely on EV/EBITDA ratio in your stock analysis, here’s your right guide. In this article, we will explore the differences between these ratios, their unique strengths, and the scenario when each of these becomes your best investment partner.

What Is the Price-to-Earnings (P/E) Ratio?

The PE ratio is the most simple and most widely used associated metric for valuing stocks. It compares a company’s current share price with its per-share earnings.

It’s a simple formula:

P/E = Price Per Share / Earnings Per Share (EPS)

The Strengths of P/E

• Simplicity 

The P/E ratio is one of the easiest ratios to compute. It offers a snapshot of how much investors are willing to pay for each dollar of earnings.

• Peer Comparisons

The P/E ratio is also helpful when comparing companies that operate within the same industry. For instance, a tech company with a P/E of 18 might look undervalued if its peers are averaging a P/E of 25.

• Market Sentiment

PE ratios that are high compared with closes competitors mean investors expect a company to show strong future growth, those that are low may signal undervaluation or concern over declining performance.

When to Use P/E

• Compare Companies From the Same Industry

If you are looking at stocks within an industry that is operated under consistent accounting practices and has similar earnings structures, then P/E can be a great first yardstick of valuation.

• Focus on Earnings Growth

For companies where earnings are expected to be steady over time (like consumer goods or established tech companies), P/E tells you how much you are paying for future earnings potential.

• For Established Companies

P/E is best suited for old companies where the earnings are relatively predictable and fewer outcomes affect them in the short term.

Limitations of P/E

The largest caveat is that the P/E ratio does not take into account a company’s debt or capital structure. That can make it unreliable for companies with high or unusual amounts of debt, or for companies in restructuring.

What Is the EV/EBITDA Ratio & When to Use It?

Enterprise Value to EBITDA (EV/EBITDA) This is a more advanced metric that assesses a company's total worth  relative to its earnings before interest, taxes, depreciation, and amortization.

Here’s the formula:

EV/EBITDA = Enterprise Value ( Market Cap + Net Debt) / EBITDA

The Strengths of EV/EBITDA

• Accounts for Debt

EV/EBITDA takes into account a company’s total debt, unlike the PE ratio. It is particularly useful for comparing companies with different capital structures (e.g., highly leveraged companies vs. low debt).

• Comparing Across Industries

EV/EBITDA also eliminates certain accounting differences (e.g., depreciation methods) that do not directly affect a company's cash flow, so it should be useful for comparing companies in diverse segments.

• Useful for Cash Flow Analysis

EBITDA is a common measure of cash flow. EV/EBITDA ratio offers greater visibility into a company’s ability to produce operating cash based on its enterprise value.

When to Use EV/EBITDA

• High Debt Level Companies

For capital-intensive segments of the economy such as utilities, telecommunications, or manufacturing, where comparatively high levels of debt are an integral part of the business, EV/EBITDA gives investors a better sense of whether they are paying a fair price to invest; this explains why it is commonly used in these industries.

• Cross-Industry Comparisons

If you are comparing companies across industries (or regions), EV/EBITDA avoids accounting difference that can create distortions in P/E ratios.

• Emphasis on Operating Performance

It focuses on operating performance (because interest and taxes are not included) and can be especially useful for companies in financial restructuring over short periods of time.

• Private and Acquisition Targets

Since EV is inclusive of debt, this ratio is widely used in mergers and acquisitions to determine the total value of a target business.

Limitations of EV/EBITDA

The EV/EBITDA ratio has a major disadvantage. It assumes that EBITDA is a good proxy for cash flow, but this is not always true. For industries that are capital intensive, ignoring capital expenditures can create an even more misleading picture.

P/E or EV/EBITDA – Which Should You Use? 

Determining the right valuation approach and which metric to use often depends on the nature of the investment and the sector you are evaluating. Here’s a side-by-side comparison to aid your decision-making process.

Real-World Example

Let's take two companies in the airline industry, each having similar revenues. But Company A has a lot of debt, and Company B has very little debt. The P/E ratio indicates company B is undervalued compared to company A, because it has lower earnings. But this analysis would tell a different story when using EV/EBITDA, providing a more fair representation of each company’s aggregate worth.

The precise analysis is done when the two ratios are combined. So first compute P/E for quick evaluation from an equity valuation standpoint. Next, add EV/EBITDA to your toolkit to better understand how debt, or unique capital structures affect a company’s value as a whole.

Conclusion

P/E and EV/EBITDA are both extremely useful metrics for any investor. The P/E provides basic simplicity and insight into market sentiment, while EV/EBITDA brings additional depth through debt consideration and operating cash flow. However, the key to successfully utilizing these ratios is knowing when and where to implement them.

When dealing with high-debt businesses, cross-industry evaluations, or acquisition cases, EV/EBITDA is generally the best option. For mature corporations or industries with relatively simple capital structures, P/E provides an intuitive and useful evaluation metric.