Price-to-earnings (P/E), given its apparent simplicity, is the most commonly used metric in the value-investing world. The ratio enjoys greater popularity among valuation metrics in the investment toolkit and is preferred while uncovering stocks trading at attractive prices. However, even this universally used valuation multiple is not without its limitations.
Although 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.
Huntsman Corporation HUN, MarineMax, Inc. HZO, Daqo New Energy Corp. DQ, PBF Energy Inc. PBF and Ryder System, Inc. R are some stocks with impressive EV-to-EBITDA ratios.
EV/EBITDA is a Better Approach, Here’s Why
EV-to-EBITDA is essentially 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, its debt and preferred stock minus cash and cash equivalents.
The other component of the multiple, EBITDA, gives a clearer picture of a company’s profitability as it strips out non-cash expenses like depreciation and amortization that reduce net earnings. It is also often used as a proxy for cash flows.
Just like P/E, the lower the EV-to-EBITDA ratio, the more appealing it is. A low EV-to-EBITDA ratio signals that a stock is potentially undervalued.
EV-to-EBITDA takes into account the debt on a company’s balance sheet that the P/E ratio does not. Due to this reason, EV-to-EBITDA is generally used to value the potential acquisition targets as it shows the amount of debt the acquirer has to assume. Stocks boasting a low EV-to-EBITDA multiple could be seen as attractive takeover candidates.
Another shortcoming of P/E is that it can’t be used to value a loss-making firm. A company’s earnings are also subject to accounting estimates and management manipulation. On the other hand, EV-to-EBITDA is difficult to manipulate and can also be used to value companies that are making loss but are EBITDA-positive.
EV-to-EBITDA is also a useful tool 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 a higher multiple and vice versa) and is usually not appropriate while comparing stocks in different industries, given their diverse capital requirements.
Therefore, instead of solely relying on EV-to-EBITDA, you can club it with the other major ratios such as price-to-book (P/B), P/E and price-to-sales (P/S) to achieve the desired outcome.
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 our five picks out of the 13 stocks that passed the screen:
Huntsman is a leading manufacturer of differentiated and commodity chemical products. This Zacks Rank #1 stock has a Value Score of A.
Huntsman has an expected earnings growth rate of 26.8% for the current year. The Zacks Consensus Estimate for HUN's current-year earnings has been revised 11.7% upward over the past 60 days.
MarineMax is a leading recreational boat and yacht retailer. This Zacks Rank #1 stock has a Value Score of A. You can see the complete list of today’s Zacks #1 Rank stocks here.
MarineMax has an expected year-over-year earnings growth rate of 21.5% for the current fiscal year. The Zacks Consensus Estimate for HZO's current fiscal year earnings has been revised 4.6% upward over the last 60 days.
PBF Energy provides end products that comprise heating oil, transportation fuels, lubricants and many related products. This Zacks Rank #1 stock has a Value Score of A.
PBF Energy has an expected earnings growth rate of 432.8% for the current year. The consensus estimate for PBF's current-year earnings has been revised 191.9% upward over the past 60 days.
Daqo New Energy is a leading producer of high-purity polysilicon. This Zacks Rank #1 stock has a Value Score of A.
Daqo New Energy has an expected earnings growth rate of 129.8% for the current year. The Zacks Consensus Estimate for DQ’s current-year earnings has been revised 26.7% upward over the past 60 days.
Ryder System is one of the world's largest providers of integrated logistics and transportation solutions. This Zacks Rank #1 stock has a Value Score of A.
Ryder System has an expected earnings growth rate of 46% for the current year. The consensus estimate for R’s current-year earnings has been revised 20% upward over the past 60 days.
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Ryder System, Inc. (R) : Free Stock Analysis Report
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DAQO New Energy Corp. (DQ) : Free Stock Analysis Report
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