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Chapter 1 of 5 · 11 min

EV/EBITDA versus P/E

One multiple prices the whole business before anyone is paid; the other prices what is left for shareholders. Walk from one to the other.

By the end of this chapter you can
  • Turn an EV/EBITDA multiple into a P/E, line by line
  • Say how D&A, debt and tax make the two multiples disagree
  • Find the EV/EBITDA that a peer P/E implies
  • Choose the fairer multiple for a comparison
1

The intuition

Two identical houses sell for the same price. One owner has a big mortgage, the other has none. Ask what the house is worth and the answer is the same. Ask what the owner's stake is worth, and what it earns after the mortgage payments, and the two answers are very different.

EV/EBITDA answers the first question: enterprise value (the whole business, debt included) over earnings before interest, tax, depreciation and amortization. P/E answers the second: equity value over net income, which is after D&A, interest and tax. The same business can sit on very different P/Es depending on its debt, its depreciation and its tax rate.

The key idea

Enterprise value = EBITDA × EV/EBITDA. Equity value = EV − net debt. Net income = (EBITDA − D&A − interest) × (1 − tax rate). P/E = equity value ÷ net income.

2

Why it works

  • The conventions here: one year, no growth. Interest = net debt × the interest rate. Net income = (EBITDA − D&A − interest) × (1 − tax rate). Equity value = EV − net debt.
  • EV/EBITDA compares businesses. Its top includes the debt and its bottom is before interest, so the capital structure largely drops out.
  • P/E compares what a shareholder buys. Top and bottom are both after the lenders, so leverage changes it even when the business is identical.
  • Heavy D&A and tax push the P/E up against EV/EBITDA: they shrink net income but not the value.
  • Debt can push the P/E either way. More debt lowers it when the after-tax cost of debt is below the earnings yield (net income ÷ equity value), and raises it when above.
  • EV/EBITDA is the wrong tool for banks and insurers, where debt is the business, and it flatters capital-heavy companies whose D&A is a real cost. There EV/EBIT or free cash flow tells the truth.
EBITDA $100M at 10.0x; D&A 20% of EBITDA; net debt 2.0x at 6%; tax 25%
Enterprise value: 100 × 10$1,000M
Equity value: 1,000 − 200$800M
EBIT: 100 − 20$80M
Interest: 200 × 6%$12M
Net income: (80 − 12) × (1 − 25%)$51M
P/E: 800 ÷ 5115.7x

Priced on a 20x peer P/E instead: 20 × 51 + 200 = $1,220M of EV, or 12.2x EBITDA.

3

The formulas

Enterprise value = EBITDA × EV/EBITDA

The whole business.

Equity value = EV − net debt

What is left for shareholders.

Net income = (EBITDA − D&A − net debt × rate) × (1 − tax)

Earnings after everyone ahead of the shareholders.

P/E = equity value ÷ net income

The shareholder's multiple.

EV/EBITDA implied by a P/E = (P/E × net income + net debt) ÷ EBITDA

Walk it back.

4

Worked example

EV down to equity value by taking off net debt; EBITDA down to net income by taking off D&A, interest and tax. Then divide.

Drawing the numbers…
5

See it move

Same company and the same EBITDA. Change the EV/EBITDA multiple, D&A, leverage, the interest and tax rates, and the peer P/E.

Drawing the numbers…
Try this
  • Raise EV/EBITDA. Net income does not move, so the P/E rises with it.
  • Raise D&A. Enterprise value does not notice; net income falls and the P/E rises.
  • Raise the tax rate. The P/E rises.
  • Raise the interest rate. The P/E rises, unless the company has no net debt.
  • Raise the peer P/E. The EV/EBITDA it implies rises.
6

Run it backwards

Same company, reversed: if it were priced on its peers' P/E, what EV/EBITDA would that be?

Drawing the numbers…

The peer P/E times net income gives an equity value. Add back net debt for enterprise value, then divide by EBITDA.

If the company trades below that multiple, either the market thinks its business deserves less than peers, or the P/E comparison flatters it because of its leverage or D&A. Find out which before calling it cheap.

7

Traps

Dividing enterprise value by net income.
Match the metric: EV with EBITDA (before the lenders), equity value with net income (after them).
Leaving out interest on the way to net income.
Net income is after interest; EBIT is not.
Comparing P/Es across different capital structures.
Leverage alone moves the P/E. Compare businesses on EV/EBITDA.
Assuming more debt always lowers the P/E.
It depends whether the after-tax cost of debt is below or above the earnings yield.
Using EV/EBITDA for a bank.
Debt is a bank's raw material. Use price to book and return on equity.
8

Say it in the interview

The interviewer asks

“Why might two companies on the same EV/EBITDA trade on very different P/Es?”

Say yours out loud first, then compare.
9

Check yourself

4 fresh questions, with new numbers. Answer each one correctly to finish the chapter. Get one wrong and you will see the full working, then you can try it again with new numbers.

Answers within 1% are marked right. Type the number; $, %, x and M are fine. First tries count toward Learned: the topic is Learned once every chapter is done and 75% of first tries were right.

0 of 4
Drawing your questions…
Remember
  • Equity value = EV − net debt.
  • Net income = (EBITDA − D&A − interest) × (1 − tax).
  • EV/EBITDA compares businesses; P/E compares equity claims.
  • D&A, debt and tax are what drive the two apart.