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 picking stocks that are trading at a bargain. However, even this straightforward, broadly used valuation metric suffers a few downsides.
EV-to-EBITDA is a Better Approach, Here’s Why
Although 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. EBITDA, the other constituent, gives a better idea of a company’s profitability as it removes the impact of 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-to-EBITDA ratio, the more appealing it is. A low EV-to-EBITDA ratio could signal 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. Another shortcoming of P/E is that it 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-to-EBITDA is difficult to manipulate and can also be used to value companies that are making 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. But EV-to-EBITDA has its downsides too. It varies across industries and is generally not appropriate while comparing stocks in different industries given their diverse capital spending requirements. Therefore, instead of just relying on EV-to-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. 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. of less than or equal to B: Value Score Here are five of the 11 stocks that passed the screen: Magna International Inc. ( MGA Quick Quote MGA - Free Report) is one of the leading automotive parts suppliers in the world. This Zacks Rank #1 stock has expected year-over-year earnings growth of 98.2% for the current year and a Value Score of B. Huntsman Corporation ( HUN Quick Quote HUN - Free Report) is a global manufacturer and marketer of differentiated and specialty chemicals. This Zacks Rank #1 stock has expected year-over-year earnings growth of 115.2% for the current year and a Value Score of B. You can see . the complete list of today’s Zacks #1 Rank stocks here Anthem, Inc. ( ANTM Quick Quote ANTM - Free Report) is a leading health benefits company. This Zacks Rank #2 stock has expected year-over-year earnings growth of 13.6% for the current year and a Value Score of A. Energy Transfer LP ( ET Quick Quote ET - Free Report) owns and operates one of the largest and most-diversified portfolios of energy assets in the United States. This Zacks Rank #2 stock has expected year-over-year earnings growth of 772.9% for the current year and a Value Score of A. CACI International Inc ( CACI Quick Quote CACI - Free Report) is a leading provider of expertise and technology to enterprise and mission customers. This Zacks Rank #2 stock has expected year-over-year earnings growth of 18.9% 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. 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