The price-to-earnings (P/E) ratio is by far the most widely used metric in value investing given its apparent simplicity. The idea of chasing stocks with a low P/E is ingrained in the minds of many investors. However, even this broadly used valuation multiple is not without its shortcomings.
What Makes EV/EBITDA a Better Choice?
Although P/E is preferred by many investors while uncovering value stocks, another valuation metric called EV/EBITDA does a better job. The ratio is sometimes viewed as a superior substitute as it offers a clearer picture of a firm’s valuation and its earnings potential. EV/EBITDA, also referred to as the enterprise multiple, has a more comprehensive approach to valuation as it determines a firm’s total value. In contrast, P/E just considers the equity portion of a firm.
EV/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, its debt and preferred stock minus cash and cash equivalents.
The other element of the multiple, EBITDA, gives the true 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.
Generally, the lower the EV/EBITDA ratio, the more attractive it is. A low EV/EBITDA ratio could signal that a stock is potentially undervalued.
EV/EBITDA takes into account the debt on a company’s balance sheet that P/E ratio does not. Given 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.
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. 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 assessing the value of firms that are highly leveraged and have a high degree of depreciation. It also 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.
As such, a strategy entirely based on EV/EBITDA might not fetch the desired outcome. But you can club it with other major ratios such as price-to-book (P/B), P/E and price-to-sales (P/S) to screen true value stocks.
Here are the parameters to screen for value 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 19 stocks that passed the screen:
Hibbett Sports, Inc. HIBB operates sporting goods stores in small and mid-sized markets. It offers convenient locations and a broad assortment of quality branded athletic footwear, apparel and equipment with a high level of customer service. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 18.1% for the current fiscal year. It also has a Value Score of A.
Comtech Telecommunications Corp. CMTL designs, develops, produces and markets innovative products, systems and services for advanced communications solutions. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 18.7% for the current fiscal and a Value Score of B. You can see the complete list of today’s Zacks #1 Rank stocks here.
Quanta Services, Inc. PWR is a leading specialized contracting services company, delivering infrastructure solutions for the electric power, oil and gas, and communications industries. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 29.5% for the current year and a Value Score of A.
Principal Financial Group, Inc. PFG helps people and companies around the world build, protect and advance their financial well-being through retirement, insurance and asset management solutions that suit their lives. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 2.9% for the current year and a Value Score of A.
Zions Bancorporation ZION is a premier financial services company in the United States. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 10.1% for the current 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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Comtech Telecommunications Corp. (CMTL) : Free Stock Analysis Report
Zions Bancorporation (ZION) : Free Stock Analysis Report
Quanta Services, Inc. (PWR) : Free Stock Analysis Report
Principal Financial Group, Inc. (PFG) : Free Stock Analysis Report
Hibbett Sports, Inc. (HIBB) : Free Stock Analysis Report
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