For Immediate Release
Chicago, IL – May 11, 2018 - Stocks in this week’s article United Natural Foods, Inc. (UNFI - Free Report) , Big 5 Sporting Goods Corporation (BGFV - Free Report) , Western Digital Corporation (WDC - Free Report) , Huntsman Corporation (HUN - Free Report) and PCM, Inc. (PCMI - Free Report) .
When (and Why) Small-Cap Stocks Started Outpacing the S&P 500
The price-to-earnings (P/E) ratio is by far the most widely used metric in value investing given its apparent simplicity. The idea of hunting stocks with a low P/E is ingrained in the minds of many investors. However, even this ubiquitously used equity valuation multiple is not devoid of limitations.
What Makes EV/EBITDA a Better Choice?
While P/E enjoys great popularity, a less-used and more-complicated metric called EV/EBITDA gains an upper hand as it offers a clearer picture of a company’s valuation and earnings potential. EV/EBITDA, also known as the enterprise multiple, has a more complete approach to valuation as it determines a firm’s total value. P/E, on the other hand, considers only 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. Simply put, it is the total value of a firm.
EBITDA, the other constituent, gives the true picture of a company’s profitability as it removes the impact of non-cash expenses like depreciation and amortization that depress net earnings. It is also often used as a proxy for cash flows.
Generally, the lower the EV/EBITDA ratio, the more attractive 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 firm’s earnings are also subject to accounting estimates and management manipulation. On the other hand, 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 measuring the value of companies that are highly leveraged and have a high degree of depreciation. Moreover, the ratio allows the comparison of companies with different debt levels.
Then again, EV/EBITDA has its flaws too. 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, a strategy solely based on EV/EBITDA might not fetch the desired outcome. But you can combine it with the other key ratios such as price-to-book (P/B), P/E and price-to-sales (P/S) to screen value stocks.
For the rest of this Screen of the Week article please visit Zacks.com at: https://www.zacks.com/stock/news/303164/when-and-why-small-cap-stocks-started-outpacing-the-sampp-500
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