Value Traps

EV/ EBITDA Versus P/B: Pros And Cons Of Both Valuation Metrics

EV/ EBITDA Versus P/B: Pros And Cons Of Both Valuation Metrics

EV/EBITDA (Enterprise value/Earnings before interest, taxes, depreciation and amortization) is one several measures used to determine a company’s real value. The greatest advantage of using this valuation is that it can be utilized to directly compare corporations in the same industry with varying debt levels. This can be a very useful tool when trying to identify under and over-valued companies. One study has shown that EV/EBITDA is the best valuation metric. EBITDA/EV is useful tool, as the reciprocate of the multiple is a good indicator of cash return on investment.

Most analysts use EV/EBITDA as a trading comparison, as investors want to see the revenue and cash producing power of the whole firm. The ratio is very rarely, if ever, applied to a straight-up valuation. The largest advantage of EV/EBITDA over the P/B rate is that the result is not influenced by the company’s corporate structure. EV/EBITDA also eliminates the effects of amortization and depreciation, which in some valuations may be more applicable. The biggest downside to using EV/EBITDA is that it is wrong for comparisons of corporations in different industries, as capital expenditure requirements are usually different. Many also make the mistake of overlooking minority interests, as this tends to be subtracted from profit, which can in turn skew the number.

P/B(Price-to-Book) is calculated by simply taking the current price of the stock times its number of shares outstanding, divided by the latest quarter’s book value. Effectively, a price to book ratio of 10 would mean that for every $1 of tangible assets, there is $10 market value. In general, the higher the P/E ratio the greater the expectations, which can ultimately prove to be both good and bad. It is good for the company and its reputation, in the sense that it shows that investors are in favor of the stock and believe in its goods and/or services. This generally provides a positive euphoria in the stock, which if played correctly, can bring solid trading gains.

On the flip side, a company with a high P/B that slightly misses on the bottom or top line of an earnings report can see their stock get slaughtered in the market due to such high expectations. Moreover, if guidance is considered subpar by analysts on the street, the stock may take a tremendous hit. Most trading patterns and reactions in a stock with a high P/B ratio are exemplified, with higher gains to the upside and sharper losses to the downside.

Some advantages of using P/B are that book value uses a cumulative amount, so the ratio is able to be applied when P/E cannot. Book value is generally a bit more stable than EPS, so it is more useful than P/E. Also, when a company is expected to go out of business, most of the time a P/BV ratio will be more useful and provide more relevant data.

Some disadvantages of P/B are that the intangibles such as brand value and trademarks are not calculated, which sometimes can have significant value. Also, accounting methods are a big factor when calculating book value, so if a company uses GAAP or IFRS, it can produce two completely different results. Moreover, technology and inflation fluctuations can also play a very big role and alter the market value of assets. In the past the P/B ratio has been widely criticized since it has never taken into account capital structure.

Each ratio has its benefits and drawbacks as neither is better than the other. Understanding which ratio to apply in order to compare apples-to-apples is essential to getting the best results, and investing wiser.

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