Why EV Multiples Are Favored Over P/E for Companies with Different Capital Structures

Valuation metrics are critical tools for investors and analysts assessing a company’s worth. While the Price-to-Earnings (P/E) ratio is a popular metric, Enterprise Value (EV) multiples such as EV/EBITDA, EV/EBIT, or EV/Sales are often preferred when evaluating companies with varying capital structures. EV multiples provide a more comprehensive and accurate view of a company’s overall value by accounting for debt, cash, and operational performance, making them ideal for cross-company comparisons. This blog explores why EV multiples are favored over P/E ratios, supported by real-world company examples, industry comparisons, and sector-specific insights.

Understanding EV Multiples and P/E Ratios

Enterprise Value (EV) Multiples

EV represents the total value of a company, including both equity and debt holders. It is calculated as:

Formula:

EV = Market Capitalization + Total Debt - Cash and Cash Equivalents

EV multiples (e.g., EV/EBITDA, EV/EBIT) measure enterprise value relative to operational metrics like earnings or revenue, providing a holistic view of a company’s value. They are particularly useful for assessing companies with diverse capital structures.

Key Features:

• Incorporates debt and cash, reflecting the full capital structure.

• Neutralizes the impact of financing decisions.

• Facilitates comparisons across companies and industries.

Price-to-Earnings (P/E) Ratio

The P/E ratio measures a company’s stock price relative to its earnings per share (EPS):

Formula:

P/E = Stock Price / Earnings Per Share

P/E focuses solely on equity value and is sensitive to capital structure, interest expenses, and share count changes (e.g., buybacks).

Key Features:

• Equity-focused, ignoring debt and cash.

• Affected by financing costs and accounting policies.

• Simple but limited for cross-company comparisons.

Why EV Multiples Are Preferred Over P/E

EV multiples address several limitations of P/E ratios, particularly when comparing companies with different capital structures. Below are the key reasons why EV multiples are favored:

1. Inclusion of Debt and Cash

EV multiples account for a company’s entire capital structure by including debt and subtracting cash. This provides a more accurate picture of a company’s total value, especially for firms with significant debt or cash reserves.

Example: Apple Inc. vs. Ford Motor Company (Technology vs. Automotive)

• Apple (2024): Apple has a low debt-to-equity ratio (~0.3) and substantial cash reserves (~$60 billion). Its EV/EBITDA (~25x) reflects its operational strength, adjusted for cash, making it comparable to other tech firms. Its P/E (~30x) is inflated by high EPS but ignores cash holdings.

• Ford (2024): Ford has a higher debt-to-equity ratio (~2.0) due to financing its manufacturing operations. Its EV/EBITDA (~8x) accounts for its debt burden, providing a clearer valuation metric. Its P/E (~12x) is lowered by interest expenses, distorting comparisons with Apple.

• Insight: EV/EBITDA enables a fair comparison between Apple and Ford by neutralizing their vastly different debt and cash positions, while P/E misleads due to financing effects.

2. Capital Structure Neutrality

P/E ratios are equity-centric and sensitive to leverage. Companies with high debt have higher interest expenses, reducing EPS and inflating P/E ratios, while equity-heavy firms may appear cheaper. EV multiples are capital structure-neutral, focusing on operational performance.

Example: Verizon Communications vs. T-Mobile US (Telecommunications)

• Verizon (2024): Verizon’s debt-heavy structure (debt-to-equity ~1.8) results in significant interest expenses, lowering EPS and increasing its P/E (~15x). Its EV/EBITDA (~7x) focuses on cash flow, ignoring leverage.

• T-Mobile (2024): T-Mobile has a lower debt-to-equity ratio (~1.2) post its Sprint merger, leading to a lower P/E (~12x). Its EV/EBITDA (~8x) aligns closely with Verizon’s, reflecting similar operational efficiency.

• Insight: EV/EBITDA facilitates direct comparisons by removing the distortion of Verizon’s higher leverage, which skews its P/E.

3. Accounting for Interest Expenses

High debt levels increase interest expenses, which reduce net income and EPS, inflating P/E ratios. EV multiples, by focusing on pre-interest metrics like EBITDA or EBIT, avoid this distortion.

Example: Delta Air Lines (Airlines)

• Delta’s 2024 financials show significant debt (~$20 billion) from fleet investments, leading to high interest expenses. Its P/E (~10x) is elevated due to reduced EPS, but its EV/EBITDA (~6x) reflects operational cash flow, making it comparable to less-leveraged airlines like Southwest (EV/EBITDA ~7x).

• Insight: EV/EBITDA is preferred for Delta because it neutralizes the impact of interest expenses, which heavily distort its P/E.

4. Comparing Companies on Equal Footing

EV multiples enable fair comparisons across companies in the same industry or sector, regardless of capital structure. This is critical for identifying undervalued or overvalued firms.

Example: Coca-Cola vs. PepsiCo (Consumer Goods)

• Both companies have similar debt-to-equity ratios (~1.5-1.6), but Coca-Cola holds more cash. In 2024, Coca-Cola’s EV/EBIT (~20x) and PepsiCo’s (~18x) allow direct comparisons of operating profitability. Their P/E ratios (~25x for Coca-Cola, ~22x for PepsiCo) vary due to cash and share count differences.

• Insight: EV/EBIT ensures consistent comparisons by accounting for cash and debt, while P/E is skewed by equity-specific factors.

5. Acquisition and Takeover Perspective

In mergers and acquisitions (M&A), EV multiples are critical because acquirers assume the target’s debt and inherit its cash. EV provides the total cost of acquisition, unlike P/E, which only reflects equity value.

Example: Microsoft’s Acquisition of Activision Blizzard (2022-2023)

• Microsoft valued Activision Blizzard using EV multiples (e.g., EV/EBITDA ~15x) to assess the total cost, including Activision’s debt and cash. P/E (~30x) was less relevant, as it ignored debt assumed in the $68.7 billion deal.

• Insight: EV multiples are standard in M&A because they capture the full financial commitment, unlike P/E.

6. Unaffected by Share Buybacks

Share buybacks reduce outstanding shares, increasing EPS and potentially lowering P/E ratios, even if the company’s value is unchanged. EV multiples are unaffected by share count changes, providing a stable valuation metric.

Example: IBM (Technology)

• IBM’s aggressive buyback program in 2024 reduced shares, boosting EPS and lowering its P/E (~14x). Its EV/EBITDA (~12x) remained stable, reflecting consistent enterprise value.

• Insight: EV/EBITDA is preferred for IBM because it avoids P/E distortions from buybacks.

Industry and Sector Comparisons

The preference for EV multiples over P/E varies by industry, driven by capital structure, debt levels, and operational characteristics. Below is a sector-wise analysis:

Technology Sector

• Characteristics: Low to moderate debt, high cash reserves (e.g., Apple, Microsoft).

• Preferred Metric: EV/EBITDA is favored due to cash-heavy balance sheets and amortization of intangibles. P/E is distorted by buybacks and cash holdings.

• Example: Alphabet’s EV/EBITDA (~20x) accounts for its $100 billion cash pile, while its P/E (~25x) is inflated by EPS boosts from buybacks.

Telecommunications Sector

• Characteristics: High debt, capital-intensive (e.g., AT&T, Verizon).

• Preferred Metric: EV/EBITDA is preferred to neutralize high interest expenses and depreciation. P/E is skewed by leverage.

• Example: AT&T’s EV/EBITDA (~6x) reflects cash flow strength, while its P/E (~10x) is elevated by debt costs.

Consumer Goods Sector

• Characteristics: Stable cash flows, moderate debt (e.g., Coca-Cola, Procter & Gamble).

• Preferred Metric: EV/EBIT is often used for consistent capital structures, but EV/EBITDA is preferred for cross-industry comparisons.

• Example: Procter & Gamble’s EV/EBIT (~18x) aligns with peers, while its P/E (~22x) varies due to cash and buybacks.

Energy Sector

• Characteristics: Capital-intensive, high debt (e.g., ExxonMobil, Chevron).

• Preferred Metric: EV/EBITDA is ideal to account for debt and depreciation. P/E is unreliable due to volatile earnings.

• Example: Chevron’s EV/EBITDA (~7x) enables comparisons with ExxonMobil, while its P/E (~12x) fluctuates with oil prices.

Financial Sector

• Characteristics: High leverage, complex capital structures (e.g., JPMorgan, Goldman Sachs).

• Preferred Metric: EV/EBIT is used for operating profitability, but P/E is less reliable due to regulatory capital and interest costs.

• Example: JPMorgan’s EV/EBIT (~12x) reflects earnings strength, while its P/E (~11x) is affected by leverage.

Practical Considerations in Choosing EV Multiples vs. P/E

When deciding between EV multiples and P/E, analysts consider:

1. Capital Structure: EV multiples are essential for companies with high debt or cash (e.g., telecom, tech).

2. Industry Norms: Capital-intensive sectors (e.g., energy, telecom) favor EV/EBITDA, while stable sectors (e.g., consumer goods) may use EV/EBIT.

3. Valuation Purpose: EV multiples are critical for M&A and cross-industry comparisons, while P/E suits equity-focused retail investors.

4. Data Availability: EV multiples require detailed debt and cash data, which may be less accessible for private firms.

Challenges and Limitations

Both metrics have limitations:

• EV Multiples: Require accurate debt and cash data; may overstate value in industries with high capital replacement needs.

• P/E: Sensitive to accounting policies, buybacks, and leverage; less comparable across firms.

• Market Volatility: Both rely on market capitalization, which can fluctuate, affecting EV and P/E.

• Industry Variability: Multiples vary widely (e.g., tech EV/EBITDA > energy), requiring sector-specific benchmarks.

Conclusion

EV multiples are favored over P/E ratios when evaluating companies with different capital structures because they provide a comprehensive, capital structure-neutral view of value. By including debt and cash, neutralizing leverage effects, and enabling fair comparisons, EV multiples (e.g., EV/EBITDA, EV/EBIT) are ideal for cross-industry analyses, M&A, and assessing firms like Apple, Verizon, or ExxonMobil. P/E ratios, while simple, are distorted by interest expenses, buybacks, and equity focus, limiting their utility for diverse capital structures.

For a well-rounded valuation, analysts should use EV multiples alongside P/E and qualitative factors, tailoring the choice to the industry and valuation context. Whether comparing tech giants or energy titans, EV multiples unlock deeper insights into a company’s true financial health and intrinsic value.