Why is EV/EBITDA often preferred over P/E for comparing companies, and what are the major pitfalls?

EV/EBITDA is arguably the most widely used multiple in professional equity analysis. It's preferred over P/E for several compelling reasons, but it also has traps that the CFA exam loves to test.

Why EV/EBITDA Over P/E?

1. Capital structure neutrality. Enterprise value = Market cap + Debt - Cash. EBITDA is a pre-interest metric. So EV/EBITDA allows you to compare companies regardless of how they're financed. Two identical businesses -- one levered, one unlevered -- will have the same EV/EBITDA but very different P/Es.

1. Accounting policy neutrality. EBITDA strips out depreciation and amortization, which differ based on accounting choices (straight-line vs. declining balance, useful life estimates). P/E is affected by these choices through net income.

1. Always positive (usually). EBITDA is rarely negative for operating businesses, so EV/EBITDA almost always produces a usable number. P/E is meaningless when earnings are negative.

Worked Example: Comparing Ashford Logistics vs. Pembrook Transport (both fictional)

On P/E alone, Pembrook looks much cheaper. But EV/EBITDA reveals they're nearly identically valued -- the P/E difference is entirely explained by Ashford's heavy debt load consuming earnings through interest expense.

Major Pitfalls

The biggest pitfall is capex intensity. A software company and a steel manufacturer might both trade at 10x EV/EBITDA, but the steel company needs $200M in annual maintenance capex while the software company needs $20M. On an EV/EBIT or EV/FCFF basis, the software company would look far cheaper.

Exam Tip: When a CFA question asks you to compare companies with different capital structures, EV/EBITDA is almost always the better choice. When it asks about capital-intensive businesses, look for EV/EBITDA pitfalls related to capex.

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