Clients may directly compare the PE ratio (price/earnings ratio) of listed companies to an EBITDA multiple (multiple of earnings before interest tax depreciation and amortisation) of a private company to establish an enterprise value. This is done to understand relative values due to the known market value of a similar listed business. This is often done without understanding that comparing EBITDA multiples and PE ratios are different metrics and comparing them is misleading . They are different ratios, they are calculated differently and although provide some form of quantum indicator, cannot be replaced one for the other.
PE ratios are calculated on a multiple of earnings after interest, tax, depreciation and amortisation and represent the “official” or “real” bottom line. They are calculated as the current share price (and market value of the business) divided by the businesses after tax earnings! EBITDA multiples are however calculated as a multiple of earnings excluding or before interest, tax, depreciation and amortisation and generally used to establish a value of a business. The EBITDA multiple essentially is a method to understand a return on cash generated by the business excluding the cost of funding the working capital of the business, the cost of funds invested in capital items such as plant, equipment and vehicles and costs of intangibles such as goodwill.
For some companies their after tax results can be considerably better than their EBITDA results, for example where they are eligible for and subsequently claim the R&D tax rebate.
Where companies have invested in significant capital equipment, the cost of this needs to be accounted for and is not evident in EBITDA multiples. The EBITDA multiple and PE ratio is determined by the market (willing buyer and willing seller) and depends on the prospect of a growth in earnings of the business and where the company is in their growth cycle.
EBITDA Multiples compared to PE Ratios
For example a company with $4m EBITDA earnings and $1.75m after tax earnings has an EBITDA multiple of 2.6 and PE ratio of 6.0, see below.
|Earnings after tax||1,750,000||x||6.0||PE Ratio||10,500,000|
For the above company, the enterprise value is calculated at $10.5m, using either the EBITDA multiple of 2.6 or the PE ratio of 6.0. As can be clearly seen the EBITDA multiples and PE ratios are significantly different however used appropriately, will provide the same enterprise value. Clearly in this instance the ratio and multiples are significantly different and therefore comparing EBITDA multiples and PE ratios is misleading.
Speak to your advisor to understand the valuation methodology appropriate for your business, whether you are selling or buying. Also review our article on why EBITDA multiples mislead.