The price-to-earnings (P/E) ratio is one of the most popular and widely used financial metrics, but it has a number of inherent flaws for which the enterprise value to EBITDA (EV/EBITDA) ratio compensates.
The EV/EBITDA ratio is a financial metric that measures the return a company makes on its capital investments. Though the calculation of this ratio can be complex, this ratio is often preferred to other return metrics because it evens out differences in taxation, capital structure and asset counting.
The P/E ratio is a valuation metric that compares a company’s stock earnings per share (EPS) to its current market price. This metric is widely known and used as an indicator of a company's future growth potential. The P/E ratio does not reveal a full picture, and it is most useful when comparing only companies within the same industry or comparing companies against the general market.
There are problems that arise for investors with the use of the P/E ratio. The earnings portion of the metric is based on an accounting value that is prime for manipulation, causing the metric’s overall reliability to be questionable. Use of the EV/EBITDA ratio helps to allay some of the P/E’s downfalls through the inclusion of interest costs, tax, depreciation and amortization (EBITDA).
The EV/EBITDA ratio is less widely published than the P/E ratio, making cross-sector comparisons difficult. The use of enterprise value (EV), while beneficial, also poses problems. This value does not always depict all of a company’s debt outstanding, and negative EV values create problems in calculation.
The P/E ratio has been established as a prime market valuation metric, and the sheer volume of current and historical data gives the metric weight in regard to stock analysis. In favor of the EV/EBITDA ratio, some analysts contend that using it instead of P/E as the primary stock valuation measure produces better investment returns.
Both metrics have inherent advantages and disadvantages, and investors are likely to gain a more clear picture of a company by considering both measures as part of the process of equity evaluation.