Valuation - Using Multiples/ Difference between EV/EBITDA and P/E

1.  Valuation Using Multiples

Valuation multiples are the quickest and easiest way to value a company, and are useful in comparing similar companies (comparable company analysis). They attempt to capture many of a firm's operating and financial characteristics (e.g. expected growth) in a single number that can be multiplied by some base financial metric (e.g. EBITDA) to yield an enterprise or equity value. Multiples are expressed as a ratio of capital investment to a financial metric attributable to providers of that capital. EV/EBITDA, EV/EBIT, Price/EPS("P/E"), Equity Value/Book Value are some of the common valuation multiples. While the first two are Enterprise Value Multiples the latter ones are Equity Value Multiples. One very important point to note about multiples is the connection between the numerator and denominator. Since enterprise value (EV) equals equity value plus net debt, EV multiples are calculated using denominators relevant to all stakeholders (both stock and debt holders). Therefore, the relevant denominator must be computed before interest expense, preferred dividends, and minority interest expense. On the other hand, equity value multiples are calculated using denominators relevant to equity holders, only. Therefore, the relevant denominator must be computed after interest, preferred dividends, and minority interest expense. The very simplicity and ease of calculation makes multiples an appealing and user-friendly method of assessing value. However there are several disadvantages as this method is static, short-term and depends on correctly valued peers.

2.  EV/EBITDA as Multiple

EV/EBITDA is a popular valuation multiple used in the finance industry to measure the value of a company. It is the most widely used valuation multiple based on enterprise value and is often used in conjunction with, or as an alternative to, the P/E ratio (Price/Earnings ratio) to determine the fair market value of a company. An advantage of this multiple is that it is capital structure-neutral, and, therefore, this multiple can be used to directly compare companies with different levels of debt. The EV/EBITDA multiple requires prudent use for companies with low profit margins; i.e. for an EBITDA estimate to be reasonably accurate, the company under evaluation must have legitimate profitability. Often, an industry average EV/EBITDA multiple is calculated on a sample of listed companies to use for comparison to the company of interest, i.e. as a benchmark.

3.  P/E as a Multiple

P/E ratio is a valuation ratio of a company's current share price compared to its per-share earnings. It is calculated as: Market Value per Share / Earnings per Share (EPS) For example, if a company is currently trading at $43 a share and earnings over the last 12 months were $1.95 per share, the P/E ratio for the stock would be 22.05 ($43/$1.95). EPS is usually from the last four quarters (trailing P/E), but sometimes it can be taken from the estimates of earnings expected in the next four quarters (projected or forward P/E). A third variation uses the sum of the last two actual quarters and the estimates of the next two quarters. It is alternatively known as "price multiple" or "earnings multiple."

4. Points to Ponder

1)      What are the situations where P/E and/or EV/EBITDA should not be used to value a company? 2)      What are the pros and cons of multiples valuation compared to a fundamental approach like DCF?