The price-to-earnings (P/E) multiple enjoys wide-scale popularity among investors seeking stocks that are trading at attractive prices. In addition to being a widely-used tool for screening stocks, P/E is also a popular metric to work out the fair market value of a firm. However, even this ubiquitously used valuation multiple has a few downsides.
EV-to-EBITDA is a Better Option, But Why?
Although P/E is the most popular valuation metric, a more complicated multiple called EV-to-EBITDA works even better. Often considered a better alternative to P/E, it gives the true picture of a company’s valuation and its earning potential, and has a more complete approach to valuation. While P/E just considers a firm’s equity portion, EV-to-EBITDA determines its total value.
EV-to-EBITDA — also known as the enterprise multiple — 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. In essence, it is the entire value of a company. The other element of the ratio, EBITDA, gives a clearer picture of a company’s profitability as it strips out non-cash expenses like depreciation and amortization that reduce net earnings. It is also often used as a proxy for cash flows. Usually, 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. Unlike the P/E ratio, EV-to-EBITDA takes debt on a company’s balance sheet into account. Due to this reason, it is typically used to value potential acquisition targets. The ratio shows the amount of debt that the acquirer has to bear. Stocks flaunting a low EV-to-EBITDA multiple could be seen as attractive takeover candidates. Another drawback of P/E is that it can’t be used to value a loss-making company. Moreover, a company’s earnings are subject to accounting estimates and management manipulation. On the contrary, EV-to-EBITDA is less amenable 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 measuring 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 devoid of limitations and it alone can’t conclusively determine a stock’s inherent potential and its future performance. The multiple varies across industries and is usually not appropriate while comparing stocks in different industries given their diverse capital expenditure requirements. Therefore, instead of solely 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 outcome. 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 29 stocks that passed the screen: Vista Outdoor Inc. ( VSTO Quick Quote VSTO - Free Report) is a leading designer, manufacturer and marketer of outdoor recreation and shooting sports products. This Zacks Rank #1 company has an expected year-over-year earnings growth rate of 66.4% for the current fiscal year and a Value Score of A. MarineMax, Inc. ( HZO Quick Quote HZO - Free Report) is a leading recreational boat and yacht retailer. This Zacks Rank #1 company has an expected year-over-year earnings growth rate of 91.2% for the current fiscal year and a Value Score of A. You can see . the complete list of today’s Zacks #1 Rank stocks here 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 153.5% for the current year and a Value Score of A. Greif, Inc. ( GEF Quick Quote GEF - Free Report) is a leading global producer of industrial packaging products and services. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 63.7% for the current fiscal year and a Value Score of B. Owens Corning ( OC Quick Quote OC - Free Report) is a leading provider of building materials systems and composite solutions. This Zacks Rank #2 company has expected year-over-year earnings growth of 68.1% 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