We often find P/E and EV/EBITDA ratios when we read fundamental stock analysis recommended by stock analysts. What is the use of the latter ratio? And what is the difference between the two ratios?

As we have previously discussed in the article on P/E or Price Earning Ratio, P/E ratio is useful to assess whether a particular stock is cheap or expensive. Many investors only use P/E ratio as a comparison and assume that low P/E means stocks of a particular company are sold at low price. This assumption is not absolutely correct. It is because it often happens that low P/E compared to the industry indicates that the company has problems. Besides, it is irrelevant to use P/E ratio to assess the company's operational performances as the net profit (loss) figures are distorted due to the application of accounting methods to profit (loss) items or due to exchange rate difference.

Therefore, fundamentalists often use EV/EBITDA as an alternative of P/E. This ratio is obtained by dividing EV (enterprise value) with EBITDA (Earnings Before Interest Tax and Depreciation).

EV is intended to obtain a proper valuation of the company using the following formula:

EV = Market Capitalization + Debt with Cash-Interest Expenses

Market Capitalization: Stock Price x Number of Outstanding Stocks

Logically, EV assesses the company by finding the market price on the left side of its balance sheet, that is, the equity and debt values, and then substract them by its cash position, which is intended to determine the net debt value of the company. Thereby EV measurement is fairer compared to mere stock price in determining the proper price of the company.

EBITDA, which is defined as earnings before (added again by) interest, tax, depreciation, and amortization expenses, is aimed to measure the ability of the company to purely produce cash flow from operational activities. EBITDA , which is usually taken from the operational cash flow, is also fairer compared to net earnings in measuring the company's ability to make profit as it is free from distortions due to the application of accounting methods to profit (loss) items.

Therefore, EV/EBITDA can be used as an alternative of P/E in deciding whether stocks of a particular company are cheap or expensive compared to other corporation in the same industry.