Price-to-earnings (P/E), due to 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 a bargain. But even this universally used valuation multiple is not without its limitations.
What Makes EV-to-EBITDA a Better Substitute?
Although P/E is hands down the most widely used equity valuation ratio in the market, a relatively less used metric called EV-to-EBITDA is often viewed as a better option as it offers a clearer picture of a company’s valuation and earnings potential. Unlike P/E that solely considers a company’s equity portion, EV-to-EBITDA determines its total value.
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, its debt and preferred stock minus cash and cash equivalents. EBITDA, the other element, 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. Typically, the lower the EV-to-EBITDA ratio, the more appealing it is. A low EV-to-EBITDA ratio could be a sign 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. For 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. P/E also can’t be used to value a loss-making firm. A company’s earnings are subject to accounting estimates and management manipulation as well. Meanwhile, EV-to-EBITDA is less open to manipulation and can also be used to value companies that are making loss but are EBITDA-positive. Moreover, EV-to-EBITDA is a useful tool in assessing the value of companies that are highly leveraged and have a high degree of depreciation. The ratio also allows the comparison of companies with different debt levels. However, EV-to-EBITDA is not without its shortcomings and alone cannot conclusively determine a stock’s inherent potential and future performance. The ratio 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-to-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 bargain stocks. Screening Criteria
Here are the parameters to screen for bargain 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. 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. Value Score of less than or equal to B: Here are five of the 11 stocks that passed the screen: through its subsidiaries, is involved in the transportation, storage, terminalling, and marketing of crude oil and refined products Plains GP Holdings, L.P. ( PAGP Quick Quote PAGP - Free Report) , through its subsidiaries, is involved in the transportation, storage, terminalling, and marketing of crude oil and refined products. This Zacks Rank #1 stock has a Value Score of A. The company beat the Zacks Consensus Estimate for earnings in three of the trailing four quarters, the average being 452.4%. Principal Financial Group, Inc. ( PFG Quick Quote PFG - Free Report) is a leader in global investment management offering businesses, individuals and institutional clients a wide range of financial products and services. This Zacks Rank #1 stock has a Value Score of A. The Zacks Consensus Estimate for the current year has been revised 4.6% upward over the last 60 days. You can see . the complete list of today’s Zacks #1 Rank stocks here Laboratory Corporation of America Holdings ( LH Quick Quote LH - Free Report) is a leading healthcare diagnostics company, providing comprehensive clinical laboratory services and end-to-end drug development support. This Zacks Rank #1 stock has a Value Score of B. The Zacks Consensus Estimate for the current year has been revised 14.2% upward over the last 60 days. Korea Electric Power Corporation ( KEP Quick Quote KEP - Free Report) generates and supplies electric power to its customers, both industrial and residential. This Zacks Rank #2 stock has expected year-over-year earnings growth of 131.5% for the current year and a Value Score of A. Piedmont Office Realty Trust, Inc. ( PDM Quick Quote PDM - Free Report) is a self-administered and self-managed real estate investment trust, focused on creating value for its shareholders through acquisition, development, ownership and progressive management of premier properties in each of its target markets. This Zacks Rank #2 stock has expected year-over-year earnings growth of 7.8% 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. 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