The price-to-earnings (P/E) multiple enjoys wide-scale popularity among investors seeking stocks trading at a bargain. In addition to being a widely used tool for screening stocks, P/E is a popular metric to work out the fair market value of a firm. But even this ubiquitously used valuation multiple has a few downsides.
While 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 earning potential, and has a more complete approach to valuation. While P/E considers a firm’s equity portion, EV-to-EBITDA determines its total value. USA Truck, Inc. ( USAK Quick Quote USAK - Free Report) , AdvanSix Inc. ( ASIX Quick Quote ASIX - Free Report) , SM Energy Company ( SM Quick Quote SM - Free Report) , Greif, Inc. ( GEF Quick Quote GEF - Free Report) and SpartanNash Company ( SPTN Quick Quote SPTN - Free Report) are some stocks with impressive EV-to-EBITDA ratios. Is EV-to-EBITDA a Better Substitute to P/E?
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. 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. Typically, the lower the EV-to-EBITDA ratio, the more appealing it is. A low EV-to-EBITDA ratio could be a sign 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 downside 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 making 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 not devoid of limitations and it alone can’t conclusively determine a stock’s inherent potential and future performance. The multiple varies across industries and is usually inappropriate while comparing stocks in different industries given their diverse capital expenditure 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 our five picks out of the 19 stocks that passed the screen: USA Truck is engaged in the transportation of general commodity freight in interstate and foreign commerce. This Zacks Rank #1 stock has a Value Score of A. USA Truck has an expected earnings growth rate of 26.9% for the current year. The Zacks Consensus Estimate for USAK’s current-year earnings has been revised 21% upward over the past 60 days. AdvanSix is a manufacturer of nylon 6 resin, chemical intermediates and ammonium sulfate fertilizer. This Zacks Rank #1 stock has a Value Score of B. You can see . the complete list of today’s Zacks #1 Rank stocks here AdvanSix has an expected earnings growth rate of 54.7% for the current year. The Zacks Consensus Estimate for ASIX's current-year earnings has been revised 43.6% 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 B. SM Energy has an expected earnings growth rate of 385.4% for the current year. The Zacks Consensus Estimate for SM’s current-year earnings has been revised 41.2% upward over the past 60 days. Greif is a leading global producer of industrial packaging products and services. This Zacks Rank #2 stock has a Value Score of A. Greif has an expected year-over-year earnings growth rate of 16.1% for the current fiscal year. The Zacks Consensus Estimate for GEF's current fiscal year earnings has been revised 4.2% upward over the past 60 days. SpartanNash distributes grocery products to a diverse group of independent and chain retailers, its corporate-owned retail stores, and U.S. military commissaries and exchanges. This Zacks Rank #2 stock has a Value Score of A. SpartanNash has an expected year-over-year earnings growth rate of 24.7% for the current year. The Zacks Consensus Estimate for SPTN's current fiscal year earnings has been revised 15.2% 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