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 attractive prices. But even this universally used valuation multiple is not without its shortcomings.
Although P/E enjoys great popularity among value investors, a less-used and more-complicated metric called EV-to-EBITDA is sometimes viewed as a better alternative. EV-to-EBITDA gives the true picture of a company’s valuation and earnings potential. It has a more comprehensive approach to valuation. Ethan Allen Interiors Inc. ( ETD Quick Quote ETD - Free Report) , SM Energy Company ( SM Quick Quote SM - Free Report) , JAKKS Pacific, Inc. ( JAKK Quick Quote JAKK - Free Report) , ScanSource, Inc. ( SCSC Quick Quote SCSC - Free Report) and Tronox Holdings plc ( TROX Quick Quote TROX - Free Report) are some stocks with alluring EV-to-EBITDA ratios. Is EV-to-EBITDA a Better Substitute to P/E?
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, its debt and preferred stock minus cash and cash equivalents.
The other component of the multiple, 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. Typically, the lower the EV-to-EBITDA ratio, the more attractive it is. A low EV-to-EBITDA ratio could be a sign that a stock is potentially undervalued. Unlike the P/E ratio, EV-to-EBITDA takes debt on a company’s balance sheet into account. For 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. Moreover, P/E can’t be used to value a loss-making firm. A firm’s earnings are also subject to accounting estimates and management manipulation. In contrast, EV-to-EBITDA is harder to manipulate and can be used to value companies that have negative net earnings but are positive on the EBITDA front. EV-to-EBITDA is also a useful tool in evaluating 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 limitations too. The ratio varies across industries (a high-growth industry typically has a higher multiple and vice versa) and is usually not appropriate while comparing stocks in different industries, given their diverse capital 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 our five picks out of the 12 stocks that passed the screen: Ethan Allen Interiors is a leading interior design company and manufacturer and retailer of quality home furnishings. This Zacks Rank #1 stock has a Value Score of A. Ethan Allen Interiors has an expected earnings growth rate of 38.4% for the current fiscal year. The Zacks Consensus Estimate for ETD's current fiscal-year earnings has been revised 5.8% upward over the past 60 days. SM Energy is an independent oil and gas company engaged in the exploration, exploitation, development, acquisition and production of natural gas and crude oil in North America. This Zacks Rank #1 stock has a Value Score of A. You can see . the complete list of today’s Zacks #1 Rank stocks here SM Energy has an expected earnings growth rate of 245.9% for the current year. The Zacks Consensus Estimate for SM’s current-year earnings has been revised 14.5% upward over the past 60 days. JAKKS Pacific is a leading designer, manufacturer and marketer of toys and consumer products sold globally. This Zacks Rank #1 stock has a Value Score of B. JAKKS Pacific has an expected earnings growth rate of 8.5% for the current year. The consensus estimate for JAKK's current-year earnings has been revised 24.9% upward over the past 60 days. ScanSource serves North America as a value-added distributor of specialty technologies, including automatic identification and point-of-sale products, and business telephone products. This Zacks Rank #2 stock has a Value Score of A. ScanSource has an expected earnings growth rate of 27% for the current fiscal year. The Zacks Consensus Estimate for SCSC's current fiscal-year earnings has been revised 6.7% upward over the past 60 days. Tronox is a leading producer of high-quality titanium products, including titanium dioxide pigment. This Zacks Rank #2 stock has a Value Score of A. Tronox has an expected earnings growth rate of 31% for the current year. The consensus estimate for TROX’s current-year earnings has been revised 7.1% upward over the past 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