When to use EV/EBITDA instead of P/E?

When do we use EV/EBITDA while valuing some sectors instead of P/E?

Let’s take the example of Airtel and IRB Infra to decode this.

EV as we know stands for Enterprise Value

It is broadly given as
EV = Market Cap + Debt – Cash

Now in some sectors, where capital intensity is large, the earnings are impacted by higher depreciation and interest.

If Capital Intensity is high, the firm will have to put in lots of money in fixed assets, and will have to borrow money to fund this capex.

Thus both interest cost and depreciation are abnormally high. This can distort the earnings, and hence the P/E ratio, especially if you are evaluating a company in its capex phases.

Hence, the need to move upwards in the P&L, and use EBITDA. Now since we are using EBITDA (a metric that includes both interest and net profit), in the numerator we need to use EV (again including both equity and debt components), in order to keep the metric consistent.

Hence we use EV/EBITDA in these cases.

Airtel and IRB

Now look at Airtel – Operating Margin is 50%, but Net Profit Margin is around 6-7%. This distorts the P/E.

Look at IRB Infra. Operating margins of 40% and Net Margin 6%

Thus, in sectors such as Infra, Capital Goods, Telecom, Metals etc, EV/EBITDA is preferred.

 

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