The price-to-earnings (P/E) ratio is broadly considered by investors as the yardstick for evaluating the fair market value of a stock. It is preferred by many investors while handpicking stocks that are trading at attractive prices. However, even this straightforward, broadly used valuation metric suffers a few downsides.
Why EV-to-EBITDA Is a Better Alternative
While the widespread use of P/E stems from its simplicity, a more-complicated metric called EV-to-EBITDA is sometimes viewed as a better approach as it offers a clearer picture of a company’s valuation and earnings potential. EV-to-EBITDA determines the total value of a firm while P/E considers only its equity portion.
Also dubbed as the enterprise multiple, 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. The other component of the ratio, EBITDA, gives a better idea 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. Just like P/E, 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. EV-to-EBITDA takes into account the debt on a company’s balance sheet that P/E ratio does not. Due to this reason, EV-to-EBITDA is generally used to value 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 key drawback of P/E is that it cannot be used to value a loss-making entity. A firm’s earnings are subject to accounting estimates and management manipulation. In contrast, EV-to-EBITDA is less amenable to manipulation and can be used to value companies that are making a 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. However, EV-to-EBITDA has its limitations too. It varies across industries and is not appropriate while comparing stocks in different industries given their diverse capital spending requirements. Thus, instead of solely banking on EV-to-EBITDA, you can club it with other key ratios in your stock investment toolkit such as price-to-book (P/B), P/E and price-to-sales (P/S) to uncover value stocks. Screening Criteria
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. 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 15 stocks that passed the screen: Boise Cascade Company ( BCC Quick Quote BCC - Free Report) operates as a wood products manufacturer and building materials distributor. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 59.8% for the current year and a Value Score of A. Comfort Systems USA, Inc. ( FIX Quick Quote FIX - Free Report) is a provider of comprehensive heating, ventilation and air conditioning installation, maintenance, repair and replacement services. This Zacks Rank #1 stock has expected year-over-year earnings growth of 16.7% for the current year and a Value Score of B. You can see . the complete list of today’s Zacks #1 Rank stocks here Celestica Inc. ( CLS Quick Quote CLS - Free Report) is one of the largest electronics manufacturing services companies in the world, serving the computer and communications sectors. This Zacks Rank #2 company has an expected year-over-year earnings growth rate of 53.7% for the current year and a Value Score of A. Amkor Technology, Inc. ( AMKR Quick Quote AMKR - Free Report) is one of the largest providers of semiconductor packaging and test services. This Zacks Rank #2 company has an expected year-over-year earnings growth rate of 78.6% for the current year and a Value Score of A. Graphic Packaging Holding Company ( GPK Quick Quote GPK - Free Report) is a leading provider of paperboard packaging solutions for a wide variety of products to food, beverage and other consumer products companies. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 20.7% 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