The price-to-earnings (P/E) ratio is the most-preferred one among valuation metrics in the investment toolkit for assessing the fair market value of a stock. Many prefer to take the P/E route in their pursuit of stocks that are trading at attractive prices. But even this widely popular equity valuation multiple has a few pitfalls.
What Makes EV/EBITDA a Better Substitute?
While P/E is the most commonly used tool for evaluating a firm’s value, another valuation metric called EV/EBITDA works even better. The ratio is often viewed as a better alternative to P/E as it offers a clearer image of a company’s valuation and its earnings potential. EV/EBITDA also has a more complete approach to valuation as it determines the total value of a firm as opposed to P/E, which considers only its equity portion.
Also referred to as the enterprise multiple, EV/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. Simply put, it is the total value of a firm.
The other constituent, EBITDA gives the true picture of a firm’s profitability as it eliminates the impact of non-cash expenses like depreciation and amortization that dilute net earnings.
Usually, the lower the EV/EBITDA ratio, the more attractive it is. A low EV/EBITDA ratio could imply that a stock is potentially undervalued and vice versa.
EV/EBITDA also takes into account the debt on a company’s balance sheet that P/E ratio ignores. This is the reason why EV/EBITDA is typically used to value potential acquisition targets. It shows the amount of debt the acquirer has to bear. Stocks with a low EV/EBITDA multiple could be seen as attractive takeover candidates.
Another major drawback 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. EV/EBITDA, in contrast, is hard to manipulate and can also be used to value firms that have negative net earnings but are positive on the EBITDA front.
Moreover, EV/EBITDA allows the comparison of companies with different debt levels and is a useful tool in measuring the value of firms that are highly leveraged and have substantial depreciation and amortization expenses.
However, EV/EBITDA is not without its limitations and it alone can’t conclusively determine a stock’s inherent potential and future performance. It varies across industries (a high-growth industry normally has higher multiple and vice versa) and is typically not appropriate while comparing stocks in different industries given their diverse capital expenditure requirements.
As such, instead of solely banking on EV/EBITDA, you can combine it with the other major ratios such as price-to-book (P/B), P/E and price-to-sales (P/S) to screen true value stocks.
Here are the parameters to screen for value stocks:
EV/EBITDA 12 Months-Most Recent less than X-Industry Median: A lower EV/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.
Value Score of less than or equal to B: 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.
Here are five of the 13 stocks that passed the screen:
ArcBest Corporation (ARCB - Free Report) provides freight transportation services and solutions. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 71.4% for 2018 and a Value Score of A.
Cabot Corporation (CBT - Free Report) is a leading global specialty chemicals and performance materials company. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 18.4% for fiscal 2018 and a Value Score of B. You can see the complete list of today’s Zacks #1 Rank stocks here.
Avianca Holdings S.A. (AVH - Free Report) owns and operates airlines. It offers passenger air transportation services and cargo air transportation services. The stock has an expected year-over-year earnings growth rate of 41.6% for 2018. It currently has a Value Score of A and a Zacks Rank #2.
PetroChina Company Limited (PTR - Free Report) is engaged in a broad range of petroleum-related activities, including the exploration, development and production of crude oil and natural gas. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 113.4% for 2018. It also has a Value Score of A.
The Finish Line, Inc. (FINL - Free Report) is a premium retailer that carries the latest and greatest shoes, apparel and accessories. This Zacks Rank #2 stock has an expected earnings per share (EPS) growth rate of 10.4% for three to five years and a Value Score of B.
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.
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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.
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