Company valuation – P/E, EV/EBITDA, ROE and DCF

Lesson 2: Ratios – P/E, EV/EBITDA, ROE, DCF

A ratio without context is dangerous. A P/E of 8 can be expensive, a P/E of 30 cheap – it depends on growth, risk, balance-sheet structure and the quality of earnings. Advanced stock picking is not sorting a table from the lowest P/E upwards, it is understanding what a ratio measures, what its limitations are and when using it in a plan is forbidden.

Lesson goal

You will understand the construction and the limitations of the four pillars of valuation: market multiples (P/E, EV/EBITDA), returns on capital (ROE/ROIC) and absolute valuation (DCF). You will learn to normalise them, compare them within a sector and tie them to risk measurement.

1. P/E – the price paid for 1 PLN of profit, but which profit?

P/E = Share price / Earnings per share (EPS)
P/E trailing = Price / sum of EPS over the last 12 months
P/E forward = Price / forecast EPS for the next 12 months
P/E adjusted = Price / EPS normalised for one-off events

Table of differences:

An advanced adjustment: P/E excluding net cash. If a company holds 30% of its market capitalisation in net cash, the effective operating P/E is lower. But that cash may be needed for CAPEX – do not adjust automatically.

2. EV/EBITDA – a valuation independent of the financing structure

EV (Enterprise Value) is the value of the whole enterprise, not just the part belonging to shareholders.

EV = Market capitalisation + Interest-bearing debt + Minority interests + Leases - Cash and equivalents
EBITDA = EBIT + Depreciation and amortisation
Adjusted EBITDA = EBITDA +/- one-off events +/- share-based compensation (SBC) – depending on the methodology
EV/EBITDA = EV / EBITDA over the last 12 months

Measurement: compare EV/EBITDA only within a sector and against the 3-year median. A deviation >30% from the sector median requires a note in your plan: what you are paying a premium for (growth, margins, ROIC) or why there is a discount (balance-sheet risk, regulation).

Supporting formulas:

EV/Sales = EV / Revenue – useful when earnings are negative, but it does not show profitability
EV/EBIT = EV / EBIT – better than EV/EBITDA for companies with high depreciation
Net debt / EBITDA – a solvency test, not a valuation, but it filters EV/EBITDA

3. ROE, ROA, ROIC – how much the capital earns

ROE = Net profit / Average shareholders' equity
ROA = Net profit / Average total assets
ROIC = NOPAT / Invested capital
NOPAT = EBIT * (1 - effective tax rate)
Invested capital = Equity + Net debt - Non-operating cash + operating leases

DuPont breaks ROE down:

ROE = (Net profit / Revenue) * (Revenue / Assets) * (Assets / Equity)
    = Net margin * Asset turnover * Financial leverage

High ROE from margin and turnover = quality. High ROE from leverage alone = fragility. Measure the 3-year trend of ROIC versus WACC (the average cost of capital). If ROIC > WACC for 5 years – that is an edge; if not – you have overpaid for growth.

4. DCF – Discounted cash flow

DCF is not the oracle of valuation, only a tool for testing assumptions. Value = the sum of future FCF discounted back to today.

A simplified structure:

FCFF_t = EBIT_t * (1 - tax) + Depreciation_t - CAPEX_t - ΔWorking capital_t
Enterprise value = Σ FCFF_t / (1+WACC)^t + Terminal value / (1+WACC)^T
Terminal value (Gordon) = FCFF_{T+1} / (WACC - g)
Equity value = Enterprise value - Net debt
Value per share = Equity value / Diluted share count

Instead of one number, build a range:

Conservative scenario: revenue growth 0-2%, EBIT margin -2 pp versus today
Base scenario: growth = sales consensus + inflation
Optimistic scenario: growth = 1.5x base, margin improvement of +1 pp
WACC range: e.g. 8%-11% for the GPW, 7%-10% for S&P 500 large caps

Your decision is not “DCF says 120 PLN, so I buy”. It is: “Under my assumptions of a 9.5% WACC and a 2.5% g, the market is pricing in revenue growth of 6% CAGR – is that achievable with the current balance sheet?”

5. Combining ratios into a decision system

Do not use ratios one at a time. An example of a filter matrix:

You have to measure every threshold against the history of the GPW sector versus the US – do not copy from the US to the GPW 1:1.

When the plan says “do not trade”

• You do not trade on a single ratio (e.g. a low P/E) without checking the balance sheet, CFO and ROIC.
• You do not trade cross-sector comparisons – the P/E of a bank and the P/E of a software company are not comparable.
• You do not trade when EPS is negative and a data provider shows the P/E as “averaged” – that is a data error.
• You do not trade a DCF when you do not understand what WACC is made of and have no sensitivity range for g and WACC.
• You do not trade a company where >50% of EBITDA is share-based compensation (SBC) added back without a dilution adjustment.
• You do not trade when EV/EBITDA is <4 but net debt/EBITDA is >4 and the company has covenants – a low multiple is a balance-sheet trap.

The mistakes that cost the most

1. A low P/E = an opportunity. Most often a low P/E means the market sees falling EPS, balance-sheet risk, a one-off profit or a declining sector. Without checking CFO and the backlog, it is a selection error.
2. Using GAAP and non-GAAP P/E interchangeably. US companies report non-GAAP EPS 20-40% higher (excluding SBC). Compare one measure consistently.
3. A DCF with a single growth path. One number gives a false sense of precision. Always build a 3x3 sensitivity table (WACC vs g vs margin).
4. Ignoring dilution in EV. The share count in the market capitalisation must be diluted (RSUs, options). Data providers often report the basic one.
5. ROE calculated on negative equity or after write-downs. After a large goodwill write-down equity falls and ROE rises artificially. Check ROIC and ROA in parallel.

A measurable exercise

Pick a sector (e.g. game development on the GPW + the US, or food retail).

1. Collect 8 companies from the sector and pull: market capitalisation, net debt, EV, EBITDA 12M, EPS TTM, the 12M EPS forecast, ROE, ROIC.
2. For each one calculate: P/E TTM, P/E forward, EV/EBITDA, net debt/EBITDA, the 3-year median ROE.
3. Calculate the sector median for each ratio and each company’s deviation from the median in %.
4. Build a DCF sensitivity table for one company: WACC 8%, 9.5%, 11% vs g 1.5%, 2.5%, 3.5% – 9 valuations. Note under which assumptions the current market price is justified.
5. Write down: which 2 companies have the highest quality by ROIC + cash conversion, and which have the lowest multiple because of balance-sheet risk.

Time: 120 minutes. Output: 1 comparison table + 1 DCF sensitivity table with a 5-sentence commentary on the assumptions.

Test yourself

1. Why can EV/EBITDA be low while the company is close to insolvency?
2. How does ROE differ from ROIC and when does ROE mislead you?
3. What does negative EV mean and does the EV/EBITDA ratio make sense then?
4. Why do you use FCFF in a DCF and not net profit?
5. How would you adjust P/E when 40% of net profit in a given year comes from a one-off property sale?

Frequently asked questions

Can I compare the P/E of the GPW with the US directly? Only with an adjustment. Different interest rates, taxes, index structure and liquidity affect the market’s median P/E. Compare within a country and a sector.

What WACC should I assume for a small NewConnect company? Higher than for a WIG20 company – a premium for size and liquidity. In practice, add 2-4 pp to the WIG20 WACC as a model starting point, but test it with a range rather than a single number and write the assumption down in your plan.

Does DCF work for banks and insurers? Not in the FCFF version. For financial institutions you use a dividend discount model (DDM) or a residual income model (the surplus over the cost of capital). The P/BV multiple plus ROE is more stable there.

Negative EV/EBITDA – what do I do? The ratio is useless. Switch to EV/Sales and an analysis of cash, the burn rate and the path to profitability. Define a cash-loss limit in your plan.

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