Value investors usually have a fixation with the price-to-earnings (P/E) strategy in their quest for stocks that are trading at attractive prices. P/E, without a shadow of doubt, is the most popular multiple used by investors to evaluate the fair market value of a stock. But even this widely-popular valuation metric is not without its pitfalls.
Is EV-to-EBITDA a Better Substitute to P/E?
While P/E is preferred by many investors to uncover value stocks, another valuation metric called EV-to-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-to-EBITDA 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-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 reduce net earnings. It is also often used as a proxy for cash flows. Generally, 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. Unlikely P/E ratio, EV-to-EBITDA takes into account the debt on a company’s balance sheet. Due to this reason, EV-to-EBITDA is generally used to value the 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. 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 loss but are EBITDA-positive. EV-to-EBITDA is also a useful yardstick in assessing the value of firms that are highly leveraged and have a high degree of depreciation. It can also be used to compare companies with different levels of debt. However, EV-to-EBITDA is also 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 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. 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 18 stocks that passed the screen: 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 #1 company has expected year-over-year earnings growth of 38.4% for the current year and a Value Score of A. Domtar Corporation ( UFS Quick Quote UFS - Free Report) manufactures and distributes a wide array of fiber-based products including communication papers, specialty and packaging papers and adult incontinence products. This Zacks Rank #1 company has expected year-over-year earnings growth of 94.3% for the current year and a Value Score of A. You can see . the complete list of today’s Zacks #1 Rank stocks here Genesco Inc. ( GCO Quick Quote GCO - Free Report) is a specialty retailer that sells footwear, headwear and accessories in retail stores across the United States and Canada. This Zacks Rank #1 company has a Value Score of A. The company beat the Zacks Consensus Estimate for earnings in three of the trailing four quarters at an average of 71.2%. MarineMax, Inc. ( HZO Quick Quote HZO - Free Report) is a leading recreational boat and yacht retailer. This Zacks Rank #2 company has an expected year-over-year earnings growth rate of 23.7% for the current fiscal year and a Value Score of A. Signet Jewelers Limited ( SIG Quick Quote SIG - Free Report) is a retailer of diamond jewelry, watches and other products. This Zacks Rank #2 company has a Value Score of A. The company beat the consensus estimate for earnings in each of the trailing four quarters at an average of 50.1%. 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