Price-to-earnings (P/E) is hands down 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. A widely favored approach by value investors is to chase stocks with a low P/E ratio. But even this equity valuation multiple is not devoid of shortcomings.
Is EV-to-EBITDA a Better Alternative to P/E?
Although P/E is by far the most-popular valuation metric, the more complicated EV-to-EBITDA does a better job in working out the fair market value of a firm. Often viewed as a better substitute to P/E, this ratio offers a clearer picture of a company’s valuation and its earnings potential.
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, debt and preferred stock minus cash and cash equivalents.
EBITDA, the other element, is a true reflection 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.
Usually, 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.
EV-to-EBITDA takes into account the debt on a company’s balance sheet that P/E ratio does not. Given 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.
Also, P/E can’t be used to value a loss-making firm. A company’s earnings are also subject to accounting estimates and management manipulation. Meanwhile, EV-to-EBITDA is less open to manipulation and can also be used to value companies that are making a 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 also not without shortcomings and it alone can’t conclusively determine a stock’s inherent potential and future performance. The multiple varies across industries and is generally not appropriate for comparing stocks in different industries due to their diverse capital requirements.
As such, a strategy solely based on EV-to-EBITDA might not yield the desired results. But you can club it with the other major ratios in your stock-investing toolbox such as price-to-book (P/B), P/E and price-to-sales (P/S) to screen value stocks.
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 five of the 16 stocks that passed the screen:
Mr. Cooper Group Inc. (COOP - Free Report) provides quality servicing, origination and transaction-based services principally to single-family residences in the United States. This Zacks Rank #1 stock has expected year-over-year earnings growth of 105.3% for the current year and a Value Score of A. You can see the complete list of today’s Zacks #1 Rank stocks here.
Comfort Systems USA, Inc. (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.
Graphic Packaging Holding Company (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 21.8% for the current year and a Value Score of A.
Amkor Technology, Inc. (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.
Celestica Inc. (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 61.1% 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.