Vignette Exercise: EV/EBITDA vs. P/E

Introduction: Understanding the Two Valuation Lenses

Ever looked at a company and wondered, “Gosh, why is its Price-to-Earnings (P/E) ratio so high while its Enterprise-Value-to-EBITDA (EV/EBITDA) is quite low?” You’re not alone. The interplay between EV/EBITDA and P/E can be downright confusing, especially when you throw in different capital structures, depreciation schedules, and corporate strategies.

This vignette exercise explores two hypothetical industrial equipment manufacturing companies—Company A and Company B—that share a similar market capitalization but differ in debt levels and depreciation approaches. By walking you through a real-life style scenario, we’ll see how these contrasts can make one company’s P/E look misleadingly rich (or cheap) while its EV/EBITDA tells a different story. After all, the ultimate goal is to avoid valuation traps that might derail your investment thesis.

The Scenario: Two Industrial Equipment Manufacturers

Imagine you’re analyzing Company A and Company B. They both build specialized machinery for construction and infrastructure projects. On the surface, they might look similar—both have roughly the same market cap and operate in the same industry. But their financial footprints diverge when it comes to capital structure, depreciation, and how they direct free cash flow.

Company A’s Traits

• High leverage: They’ve been taking on debts aggressively, resulting in a large interest expense.
• Moderate capital expenditures (capex) but relatively low depreciation.
• Minimal dividend payouts: Management is more focused on meeting debt obligations than distributing cash.
• EBITDA stands tall relative to net income, mainly because the interest expense heavily reduces net income.

Company B’s Traits

• Primarily equity-financed, which means less interest expense but a potentially higher tax burden.
• Significantly higher depreciation expense thanks to large capex in prior years.
• Stable free cash flow: Lower debt service costs, but the depreciation lowers reported net income.
• Profit metrics are more “hit” by intangible accounting items like depreciation than by interest expenses.

If you compare these two side by side, you’ll see a clash of capital structure and depreciation. That’s where EV/EBITDA and P/E become immensely relevant.

EV/EBITDA vs. P/E: Distinguishing the Two

We know from earlier chapters that market-based valuation hinges on ratios that quickly convey how a company’s stock price relates to its fundamentals. Let’s do a quick refresher on why these two multiples differ so much.

EV/EBITDA

Enterprise Value (EV) is the sum of the company’s market capitalization plus outstanding debt, minus cash and cash equivalents. It’s a more capital-structure-neutral view because it includes debt holders and equity holders. EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) ignores depreciation and interest expenses.

• Strengths:
– Captures the total value attributed to both debt and equity claims.
– Strips out depreciation and amortization, making comparisons among firms with different depreciation methods somewhat fairer.
– Less sensitive to leverage decisions on the earnings side (interest expense is excluded).

• Weaknesses:
– Ignores legitimate costs such as depreciation (which, for some industries, is large and very relevant).
– Can underrepresent capital-intensive companies where depreciation is a substantial portion of costs.
– Fails to reflect how significant debt obligations might weigh on the future.

P/E (Price-to-Earnings)

P/E is the ratio of a firm’s share price to its earnings per share. In other words, it’s how much investors pay for each dollar of net income.

• Strengths:
– Intuitive and easy to communicate to a broad audience.
– Useful when interest expense, tax rates, and capital dynamics are stable or broadly comparable.

• Weaknesses:
– Highly sensitive to leverage (more debt can depress net income and inflate the P/E ratio).
– Can be prone to distortion when non-cash items like depreciation or amortization significantly affect earnings.
– If net income is near zero (or negative), the P/E ratio can be extremely volatile or meaningless.

Key Analysis Points: A Tale of Two Capital Structures

Capital Structure Influence

• Company A, with high debt, faces notable interest expenses that reduce net income. This scenario often leads to a higher P/E ratio—simply because net income is deflated (the denominator in P/E shrinks). However, the massive interest doesn’t affect EBITDA, so the EV/EBITDA ratio might look appealingly low. On the surface, you might think, “Wow, Company A is cheap based on EV/EBITDA,” but be cautious: that high leverage introduces more risk, and that’s not always visible in the EV/EBITDA multiple.

• Company B, with low debt, sees less interest expense. Net income is higher, which can lower P/E. If you just glanced at the P/E between both firms, you might assume that Company B is “cheaper,” without realizing the big chunk that depreciation takes out of its EBITDA. So, for B, EV/EBITDA ends up looking somewhat high.

Depreciation Impact

Depreciation is a non-cash expense representing the consumption of fixed assets over time. Yet it’s still an expense that reflects real economic wear and tear on assets:

• Company A’s depreciation is low (and capex is moderate). That keeps EBITDA close to operating income, arguably making EV/EBITDA a more favorable figure.
• Company B has high depreciation from its prior heavy capex. This drags down EBITDA, making EV/EBITDA look high. But in reality, the company has physically upgraded its infrastructure, which might keep future expenses lower down the line.

Growth Prospects and Timing

Don’t forget the timeline factor. If Company B’s heavy depreciation is mostly front-loaded and will taper in future years, forward-looking EBITDA could spike. Meanwhile, Company A might face ballooning interest payments or have to refinance debt at higher rates, changing the picture entirely. This is why forward multiples or a dynamic model (like two-stage or three-stage DDM or FCFE) can be super helpful in bridging discrepancies.

Vignette Examination

In a CFA exam context, you’ll typically see a story about how each company’s reported multiples appear at first glance. The exam might ask which firm is truly undervalued or to explain why a ratio is misleading. Always keep an eye out for:
• Debt levels and repayment schedules.
• Capex patterns, depreciation schedules, and how these shift net income or EBITDA over time.
• Possibly intangible factors like brand recognition, R&D expenses, or patent amortizations that can further cloud net income calculations.

Often, a question can revolve around explaining the difference between “apparent undervaluation” and the “normalized picture.” Make sure you adjust or interpret the ratios in a way that aligns with the companies’ unique capital structures and depreciation realities.

Best Practices and Pitfalls in Using EV/EBITDA vs. P/E

• Look at Both: It might sound obvious, but it’s easy to latch onto a single multiple that appears telling. In practice, combining EV/EBITDA and P/E can serve as a checks-and-balances approach.
• Adjust When Necessary: For instance, if a company’s depreciation is “unusually” high for just a year or two, consider normalizing it or looking forward. Similarly, if interest expense is temporarily low, remember it could jump once variable rates adjust.
• Study the Trend, Not Just the Snapshot: Historically, has a particular firm always had a high P/E or low EV/EBITDA? There might be structural reasons. Understanding these reasons can help you avoid over- or underestimating a firm’s performance.
• Mind the Sector Differences: Debt usage and depreciation schedules can vary by industry. Industrial equipment manufacturing companies typically have more significant capital expenditures than, say, software firms. So what’s “normal” for one sector can be extreme for another.

Visualizing EV/EBITDA vs. P/E

Below is a simple Mermaid diagram illustrating the conceptual interplay between EV/EBITDA and P/E, demonstrating how leverage and depreciation might funnel into different ratios:

    graph LR
	    A["Capital Structure <br/> (Leverage)"] --> B["Interest Expense <br/>Impacts Net Income"];
	    B --> C["Net Income Affects <br/> P/E Ratio"];
	    A --> D["Debt Affects <br/> Enterprise Value"];
	    D --> E["EV Impacts <br/> EV/EBITDA Ratio"];
	    F["Depreciation/Amortization <br/> (Non-Cash Expense)"] --> G["Reduces EBITDA"];
	    G --> E
	    F --> H["Also Reduces <br/> Net Income"];
	    H --> C

• Notice how both capital structure (which shapes EV and interest expense) and depreciation can affect the EBITDA and net income lines differently.
• The result is two different pictures provided by EV/EBITDA vs. P/E.

Practical Example: Hypothetical Numbers

Let’s do a quick numeric illustration, focusing on a single year. (Just watch for the oversimplification, though—it’s mainly to get the point across.)

• Company A (High Debt):
– EBITDA = $200M
– Interest Expense = $50M
– Depreciation = $30M
– Taxes = 25% of (EBIT)
– Assume Market Cap = $1B, Net Debt = $500M

Let’s compute net income quickly:
EBIT = EBITDA – Depreciation = $200M – $30M = $170M
EBT = $170M – $50M = $120M
Taxes = 25% × $120M = $30M
Net Income = $120M – $30M = $90M

P/E = Market Cap / Net Income = $1B / $90M ≈ 11.1×
EV = Market Cap + Net Debt = $1B + $500M = $1.5B
EV/EBITDA = $1.5B / $200M = 7.5×

• Company B (Low Debt, High Depreciation):
– EBITDA = $160M
– Interest Expense = $10M
– Depreciation = $60M
– Taxes = 25% of (EBIT)
– Market Cap = $1B, Net Debt = $50M

EBIT = $160M – $60M = $100M
EBT = $100M – $10M = $90M
Taxes = 25% × $90M = $22.5M
Net Income = $90M – $22.5M = $67.5M

P/E = $1B / $67.5M ≈ 14.8×
EV = $1B + $50M = $1.05B
EV/EBITDA = $1.05B / $160M ≈ 6.6×

Notice something? Company B’s P/E of 14.8× looks less attractive (i.e., higher multiple) than Company A’s 11.1×, mainly because Company B’s net income is somewhat constrained by large depreciation. On the other hand, Company B’s EV/EBITDA of 6.6× is actually lower (suggesting “cheaper”) than Company A’s 7.5×, reflecting that the high depreciation is taking a bigger bite out of B’s EBITDA. Meanwhile, Company A looks better on a P/E basis but is saddled with significantly higher debt. Would you rather hold the leveraged entity or the equity-financed one? That’s the art (and risk) of interpreting multiples.

Conclusion: Tying It All Together

The driving lesson here is that multiples are just signposts. They don’t “prove” anything alone, but they do guide us toward key questions about a firm’s capital structure, depreciation methods, capex, and more. For an exam or real-world scenario, the best approach is to be aware of the differences, interpret them carefully, and cross-check with additional data (like free cash flow or forward earnings).

At Level II of the CFA® Program, you’ll see item sets that make you weigh these complexities under exam pressure. The temptation might be to pick whichever ratio “looks best”—but deeper analysis is crucial. Ask yourself: “Is that ratio telling the full story, or is it overshadowed by intangible ‘wrinkles’ in the company’s financials?” In short, evaluate them both. Then decide which one best suits the underlying realities of the business.

References and Further Reading

• S&P Global Market Intelligence: Case Studies on Comparing EV/EBITDA vs. P/E in Industrial Sectors
• CFA Institute, “Financial Reporting and Analysis”
• Damodaran, A., “Investment Valuation: Tools and Techniques for Determining the Value of Any Asset”
• Corporate Finance lectures and resources on capital structure effects on valuation

Test Your Knowledge: EV/EBITDA vs. P/E in Practice