The price-to-earnings (P/E) ratio is broadly considered by investors as a yardstick for assessing the fair market value of a stock. The idea of hunting for stocks with a low P/E is ingrained in the minds of many value investors. But even this straightforward, broadly used valuation metric suffers a few downsides.

What Makes EV/EBITDA a Better Alternative?

Although P/E is preferred by many investors while uncovering bargain stocks, another valuation metric called EV/EBITDA does a better job. The ratio is sometimes viewed as a superior substitute as it offers a clearer picture of a firm’s valuation and its earnings potential. EV/EBITDA has a more comprehensive approach to valuation as it determines a firm’s total value. In contrast, P/E just considers a firm’s equity portion.

Also known as the enterprise multiple, EV/EBITDA is the enterprise value (EV) of a stock divided by its earnings before interest, taxes, depreciation, and amortization (EBITDA). EV is the sum of a company’s market capitalization, its debt and preferred stock minus cash and cash equivalents.

EBITDA, the other element, gives the true picture of a company’s profitability as it removes the impact of non-cash expenses like depreciation and amortization that depress net earnings. It is also often used as a proxy for cash flows.

Generally, the lower the EV/EBITDA ratio, the more alluring it is. A low EV/EBITDA ratio could signal that a stock is potentially undervalued.  

EV/EBITDA also takes into account the debt on a company’s balance sheet that P/E does not. Due to this reason, EV/EBITDA is generally used to value potential acquisition targets as it shows the amount of debt the acquirer has to assume. Stocks with a low EV/EBITDA multiple could be seen as attractive takeover candidates.

Another major drawback of P/E is that it can’t be used to value a loss-making entity. Moreover, a firm’s earnings are subject to accounting estimates and management manipulation. On the other hand, EV/EBITDA is less open to manipulation and can also be used to value companies that are making loss but are EBITDA-positive.