The price-to-earnings (P/E) ratio is widely considered by investors as the yardstick for evaluating the fair market value of a stock. It is preferred by many investors to handpick stocks trading at attractive prices. However, even this universally used valuation multiple is not without its limitations.
Why is EV-to-EBITDA a Better Alternative?
While P/E enjoys great popularity among value investors, a less-used and more-complicated metric called EV-to-EBITDA is sometimes viewed as a better alternative. EV-to-EBITDA gives the true picture of a company’s valuation and earnings potential. It has a more comprehensive approach to valuation.
EV-to-EBITDA is the enterprise value (EV) of a stock divided by its earnings before interest, taxes, depreciation and amortization (EBITDA). EV is the sum of a company’s market capitalization, debt and preferred stock minus cash and cash equivalents.
EBITDA, the other component of the multiple, gives a clearer picture of a company’s profitability as it removes the impact of non-cash expenses like depreciation and amortization that depress net earnings. It is also often used as a proxy for cash flows.
Usually, the lower the EV-to-EBITDA ratio, the more attractive it is. A low EV-to-EBITDA ratio could signal that a stock is potentially undervalued.
However, unlike P/E ratio, EV-to-EBITDA takes into account the debt on a company’s balance sheet. Given this reason, EV-to-EBITDA is usually used to value possible acquisition targets. Stocks with a low EV-to-EBITDA multiple could be seen as potential takeover candidates.
Moreover, P/E can’t be used to value a loss-making firm. A firm’s earnings are also subject to accounting estimates and management manipulation. In contrast, EV-to-EBITDA is harder to manipulate and can also be used to value companies that have negative net earnings but are positive on the EBITDA front.
EV-to-EBITDA is also a useful yardstick in measuring the value of firms that are highly leveraged and have a high degree of depreciation. Moreover, it can be used to compare companies with different levels of debt.
But EV-to-EBITDA has its limitations too. The ratio varies across industries (a high-growth industry typically has higher multiple and vice versa) and is usually not appropriate while comparing stocks in different industries given their diverse capital requirements.
As such, a strategy solely based on EV-to-EBITDA might not yield the desired results. But you can club it with the other major ratios in your stock investing toolbox such as price-to-book (P/B), P/E and price-to-sales (P/S) to screen value stocks.
Here are the parameters to screen for value stocks:
EV-to-EBITDA 12 Months-Most Recent less than X-Industry Median: A lower EV-to-EBITDA ratio represents a cheaper valuation.
P/E using (F1) less than X-Industry Median: This metric screens stocks that are trading at a discount to their peers.
P/B less than X-Industry Median: A lower P/B compared with the industry average implies that the stock is undervalued.
P/S less than X-Industry Median: The lower the P/S ratio, the more attractive the stock is as investors will have to pay a smaller price for the same amount of sales generated by the company.
Estimated One-Year EPS Growth F(1)/F(0) greater than or equal to X-Industry Median: This parameter will help in screening stocks that have growth rates higher than the industry median. This is a meaningful indicator as decent earnings growth always adds to investor optimism.
Average 20-day Volume greater than or equal to 100,000: The addition of this metric ensures that shares can be traded easily.
Current Price greater than or equal to $5: This parameter will help in screening stocks that are trading at a minimum price of $5 or higher.
Zacks Rank less than or equal to 2: No screening is complete without the Zacks Rank, which has proven its worth since inception. It is a fundamental truth that stocks with a Zacks Rank #1 (Strong Buy) or 2 (Buy) have always managed to beat adversities and outperform the market.
Value Score of less than or equal to B: Our research shows that stocks with a Value Score of A or B when combined with a Zacks Rank #1 or 2 offer the best upside potential.
Here are five of the 21 stocks that passed the screen:
Magna International Inc. MGA is one of the leading automotive parts suppliers in the world. This Zacks Rank #1 stock has expected year-over-year earnings growth of 87.9% for the current year and a Value Score of A.
Genesco Inc. GCO is a specialty retailer that sells footwear, headwear and accessories in retail stores across the United States and Canada. This Zacks Rank #1 company has a Value Score of A. The company beat the Zacks Consensus Estimate for earnings in three of the trailing four quarters at an average of 71.2%. You can see the complete list of today’s Zacks #1 Rank stocks here.
USA Truck, Inc. USAK is engaged in the transportation of general commodity freight in interstate and foreign commerce. This Zacks Rank #1 company has expected year-over-year earnings growth of 130.9% for the current year and a Value Score of A.
LG Display Co., Ltd. LPL manufactures and sells thin film transistor liquid crystal and organic light emitting diode display panels. This Zacks Rank #2 company has expected year-over-year earnings growth of 1,363.6% for the current year and a Value Score of A.
Owens Corning OC is a leading provider of building and industrial materials. This Zacks Rank #2 company has expected year-over-year earnings growth of 24.9% for the current year and a Value Score of A.
You can get the rest of the stocks on this list by signing up now for your 2-week free trial to the Research Wizard and start using this screen in your own trading. Further, you can also create your own strategies and test them first before taking the investment plunge.
The Research Wizard is a great place to begin. It's easy to use. Everything is in plain language. And it's very intuitive. Start your Research Wizard trial today. And the next time you read an economic report, open up the Research Wizard, plug your finds in, and see what gems come out.
Click here to sign up for a free trial to the Research Wizard today.
Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.
Disclosure: Performance information for Zacks’ portfolios and strategies are available at: https://www.zacks.com/performance.
Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free report
Magna International Inc. (MGA) : Free Stock Analysis Report
Owens Corning Inc (OC) : Free Stock Analysis Report
LG Display Co., Ltd. (LPL) : Free Stock Analysis Report
Genesco Inc. (GCO) : Free Stock Analysis Report
USA Truck, Inc. (USAK) : Free Stock Analysis Report
To read this article on Zacks.com click here.