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 trading at a bargain. But even this universally used valuation multiple is not without its shortcomings.
Is EV-to-EBITDA a Better Substitute 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 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. EBITDA, the other element of the ratio, 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. Just like P/E, the lower the EV-to-EBITDA ratio, the more appealing it is. A low EV-to-EBITDA ratio signals that a stock is potentially undervalued. EV-to-EBITDA takes into account the debt on a company’s balance sheet that the P/E ratio does not. 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. Another key downside of P/E is that it can’t be used to value a loss-making entity. Moreover, 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 incurring losses 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 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 bargain stocks. 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. Value Score of less than or equal to B: Here are five of the 25 stocks that passed the screen: United Natural Foods, Inc. ( UNFI Quick Quote UNFI - Free Report) is a leading distributor of natural, organic and specialty food and non-food products in the United States and Canada. This Zacks Rank #1 stock has a Value Score of A. United Natural Foods has an expected year-over-year earnings growth rate of 7.7% for the current fiscal year. The Zacks Consensus Estimate for UNFI's current fiscal year earnings has been revised 19.4% upward over the last 60 days. TravelCenters of America Inc. ( TA Quick Quote TA - Free Report) is the largest publicly traded full-service travel center network in the United States. TA, flaunting a Zacks Rank #1, has a Value Score of A. You can see . the complete list of today’s Zacks #1 Rank stocks here TravelCenters of America has an expected year-over-year earnings growth of 362.6% for the current year. The consensus estimate for TA’s current-year earnings has been revised 52.4% upward over the last 60 days. GMS Inc. ( GMS Quick Quote GMS - Free Report) is a distributor of wallboard and suspended ceilings systems. This Zacks Rank #1 stock has a Value Score of A. GMS has an expected year-over-year earnings growth of 87.9% for the current fiscal year. The Zacks Consensus Estimate for GMS’ current fiscal year earnings has been revised 17.7% upward over the last 60 days. 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. CLS, a Zacks Rank #2 stock, has a Value Score of A. Celestica has an expected year-over-year earnings growth rate of 26.5% for the current year. CLS’ consensus estimate for the current year has been revised 6.9% upward over the last 60 days. Covenant Logistics Group, Inc. ( CVLG Quick Quote CVLG - Free Report) , together with its subsidiaries, offers a portfolio of transportation and logistics services. CVLG, a Zacks Rank #2 stock, has a Value Score of A. Covenant Logistics has an expected year-over-year earnings growth rate of 229.6% for the current year. The Zacks Consensus Estimate for CVLG's current-year earnings has been revised 2.3% upward over the last 60 days. 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