The price-to-earnings (P/E) ratio is broadly considered by investors as a yardstick for assessing the fair market value of a stock. Many prefer to take the P/E route in their quest for stocks that are trading at attractive prices. However, even this widely popular valuation metric is not without its pitfalls.
Is EV/EBITDA a Better Alternative to P/E?
Although P/E is hands down the most widely used equity valuation ratio in the market, a relatively less-used metric called EV/EBITDA is often viewed as a better option as it offers a clearer image of a company’s valuation and earnings potential. Unlike P/E that solely considers a company’s equity portion, EV/EBITDA determines its total value.
Also dubbed as the enterprise multiple, EV/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. Essentially, it is the total value of a company.
EBITDA, the other constituent, is a true reflection 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/EBITDA ratio, the more appealing it is. A low EV/EBITDA ratio could be a sign that a stock is potentially undervalued.
However, unlike P/E ratio, EV/EBITDA takes into account the debt on a company’s balance sheet. For this reason, EV/EBITDA is usually used to value possible acquisition targets. Stocks with a low EV/EBITDA multiple could be seen as potential takeover candidates.
P/E also 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/EBITDA is difficult to manipulate and can also be used to value companies that are making loss but are EBITDA-positive.
EV/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.
However, EV/EBITDA has its limitations too. It varies across industries and is generally not appropriate while comparing stocks in different industries given their diverse capital spending requirements.
Thus, instead of just relying on EV/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 results.
Here are the parameters to screen for bargain stocks:
EV/EBITDA 12 Months-Most Recent less than X-Industry Median: A lower EV/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 11 stocks that passed the screen:
US Foods Holding Corp. USFD is a foodservice distributor that serves independent and multi-unit restaurants, healthcare and hospitality entities, and government and educational institutions. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 13.3% for the current year and a Value Score of A.
Pampa Energia S.A. PAM is an integrated electricity company engaged in the generation, transmission and distribution of electricity in Argentina. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 369.9% for the current year and a Value Score of A. You can see the complete list of today’s Zacks #1 Rank stocks here.
Hertz Global Holdings, Inc. HTZ is a key player in the vehicle rental industry. It operates its vehicle rental business globally mainly through the Hertz, Dollar and Thrifty brands. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 829.4% for the current year and a Value Score of A.
Lions Gate Entertainment Corp. LGF.A is engaged in motion picture production and distribution, television programming, home entertainment, interactive ventures, and games and location-based entertainment. This Zacks Rank #2 stock has expected year-over-year earnings growth of 14.9% for the current fiscal year and a Value Score of A.
GMS Inc. GMS is a distributor of wallboard and suspended ceilings systems. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 11.1% for the current fiscal year and a Value Score of B.
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.
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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.
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Pampa Energia S.A. (PAM) : Free Stock Analysis Report
Hertz Global Holdings, Inc (HTZ) : Free Stock Analysis Report
GMS Inc. (GMS) : Free Stock Analysis Report
US Foods Holding Corp. (USFD) : Free Stock Analysis Report
Lions Gate Entertainment Corp. (LGF.A) : Free Stock Analysis Report
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