The price-to-earnings (P/E) ratio is widely considered by investors as a yardstick for evaluating the fair market value of a stock. Many value investors prefer to take the P/E route in their quest for stocks that are trading at bargain prices. However, even this ubiquitously used equity valuation multiple is not devoid of limitations.
Is EV/EBITDA a Better Alternative to P/E?
While P/E enjoys significant popularity in the value investing world, a more complicated metric called EV/EBITDA gains an upper hand as it offers a clearer image of a firm’s valuation and earnings potential. EV/EBITDA, also referred to as enterprise multiple, determines the total value of a firm while P/E considers just its equity portion.
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. In a nutshell, it is the entire value of a company.
The other constituent of the ratio, EBITDA is a true reflection of a company’s profitability as it strips out non-cash expenses like depreciation and amortization that dilute net earnings. It is also often used as a proxy for cash flows.
Usually, the lower the EV/EBITDA ratio, the more enticing it is. A low EV/EBITDA ratio could signal that a stock is potentially undervalued.
However, unlike P/E ratio, EV/EBITDA takes into account the debt on a company’s balance sheet. For this reason, EV/EBITDA is usually used to value possible acquisition targets. Stocks with a low EV/EBITDA multiple could be seen as potential takeover candidates.
Moreover, P/E can’t be used to value a loss-making firm. A company’s earnings are also subject to accounting estimates and management manipulation. In contrast, EV/EBITDA is difficult to manipulate and can also be used to value companies that are making loss but are EBITDA-positive
EV/EBITDA is also a useful tool in assessing the value of firms that are highly leveraged and have a high degree of depreciation. Moreover, the ratio allows the comparison of companies with different debt levels.
However, EV/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, instead of just 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 14 stocks that passed the screen:
United Natural Foods, Inc. (UNFI - Free Report) is a leading publicly traded wholesale distributor to the natural, organic and specialty industry in the United States and Canada. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 19.1% for 2018 and a Value Score of A.
Western Digital Corporation (WDC - Free Report) addresses ever-changing market needs by providing a full portfolio of compelling, high-quality storage solutions with customer-focused innovation, high efficiency, flexibility and speed. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 52.1% for fiscal 2018 and a Value Score of A. You can see the complete list of today’s Zacks #1 Rank stocks here.
Conduent Incorporated (CNDT - Free Report) is a business process services company. The stock has an expected year-over-year earnings growth rate of 28.2% for 2018. It currently has a Value Score of A and a Zacks Rank #1.
ArcBest Corporation (ARCB - Free Report) provides freight transportation services and solutions. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 72.9% 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 #2 stock has an expected year-over-year earnings growth rate of 18.4% for fiscal 2018 and a Value Score of B.
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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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