While valuing companies, analysts use different methods to determine if a particular company is undervalued or overvalued.
And two most commonly used ratios are the P/E ratio and EV/EBITDA ratio.
Before understanding which one is better, let’s understand these ratios⤵️
And two most commonly used ratios are the P/E ratio and EV/EBITDA ratio.
Before understanding which one is better, let’s understand these ratios⤵️
The first is the P/E Ratio, calculated as share price/Eearning per share; it measures the money investors are willing to pay for every rupee a company earns.
But what are the drawbacks of the P/E Ratio?🤔
But what are the drawbacks of the P/E Ratio?🤔
➡️Ignores the impact of debt:
Price to earning compares price of share with that of earnings that are available to shareholders(EPS), so it measures only equity value of the company & ignores debt component, so companies that normally have high debt get low P/E ratios.
Price to earning compares price of share with that of earnings that are available to shareholders(EPS), so it measures only equity value of the company & ignores debt component, so companies that normally have high debt get low P/E ratios.
➡️Can be manipulated easily:
Since it considers earnings per share, the management of a company may manipulate the Ratio through specific accounting techniques using the loopholes in the system.
Since it considers earnings per share, the management of a company may manipulate the Ratio through specific accounting techniques using the loopholes in the system.
➡️Also, the P/E ratio is influenced by the market perceptions because the price of a share is determined by the investors, and therefore some companies may get a higher valuation than others.
For example, companies in high-growth sectors with disruptive potential may get a high valuation, or companies with good brand value and reputed management may be valued higher than peers.
Talking about EV/EBITDA ratio, it has two components: EV & EBITDA.
EV, or Enterprise value is the total value of a company that someone has to pay if they had to acquire the firm.
Enterprise Value = Market Value of Equity + Market Value of Debt - Cash in hand.
EV, or Enterprise value is the total value of a company that someone has to pay if they had to acquire the firm.
Enterprise Value = Market Value of Equity + Market Value of Debt - Cash in hand.
Let’s understand it with an example, say you want to buy a shop which is selling at Rs. 10,00,000🏬
The seller of the shop has taken a loan of Rs. 2,00,000 for the maintenance of the shop, which you would have to pay in case you acquire the shop.
The seller of the shop has taken a loan of Rs. 2,00,000 for the maintenance of the shop, which you would have to pay in case you acquire the shop.
Also, the shop has tijori 🎁which has around Rs. 3,00,000 cash, which you would get in case you buy the shop.
So your acquisition's actual value or enterprise value would be:
Rs.10,00,000 + Rs. 2,00,000 - Rs. 3,00,000
= Rs. 9,00,000.
So your acquisition's actual value or enterprise value would be:
Rs.10,00,000 + Rs. 2,00,000 - Rs. 3,00,000
= Rs. 9,00,000.
The other part of the metric is the EBITDA, which is also known as the operating profit.
It is the earning before interest cost, tax, depreciation & amortisation, & appears in the firm’s income statement.
Another way is by adding depreciation, int cost & tax to net earnings.
It is the earning before interest cost, tax, depreciation & amortisation, & appears in the firm’s income statement.
Another way is by adding depreciation, int cost & tax to net earnings.
EV/EBITDA basically tells you the payback period of your investments, say the EV of a company is Rs. 2000 cr, and the annual earnings ( EBITDA ) of a company is Rs. 200 cr, it implies that the firm can repay its entire cost of acquisition to the buyer in 10 years.
Which one is better? 🤔
P/E is a good measure for valuing the equity of the company. Since it considers the residual profit (EPS) as the denominator, EV/EBITDA is a better measure of valuation, especially when one is looking at mergers and acquisitions.
P/E is a good measure for valuing the equity of the company. Since it considers the residual profit (EPS) as the denominator, EV/EBITDA is a better measure of valuation, especially when one is looking at mergers and acquisitions.
EV/EBITDA is ideal for valuing companies in the telecommunication, cement & steel sectors, as companies in these sectors carry a high debt in their balance sheets & have high gestation periods.
EV/EBITDA is also a better measure when valuing companies that are making losses at net earnings level while their operating profits are positive.
P/E ratio is better when valuing companies in industries, where growth is high, & industry is not capital-intensive such as IT.
P/E ratio is better when valuing companies in industries, where growth is high, & industry is not capital-intensive such as IT.
While EV & EBITDA are not the sole metrics to consider in valuation, there are other methods as well, which you can learn in-depth in Quest's Value Investing Course - bit.ly
Also, retweet🔁 to educate more people!
Also, retweet🔁 to educate more people!
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