The price-to-earnings (P/E) ratio is the most-preferred among valuation metrics in the investment toolkit for evaluating the fair market value of a stock. Many prefer to take the P/E route in their pursuit for stocks that are trading at attractive prices. However, even this widely-popular equity valuation multiple suffers a few drawbacks.
Why EV/EBITDA is a Better Option?
Although P/E is the most commonly used tool for assessing a firm’s value, another valuation metric called EV/EBITDA does a better job. The ratio offers a clearer picture of a firm’s valuation and earnings potential. EV/EBITDA, also referred to as the enterprise multiple, determines the total value of a firm, while P/E just considers 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.
EBITDA, the other constituent, 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.
Generally, the lower the EV/EBITDA ratio, the more appealing it is. A low EV/EBITDA ratio could signal that a stock is potentially undervalued.
EV/EBITDA takes debt on a company’s balance sheet into account that P/E does not. Due to this reason, EV/EBITDA is typically used to value possible acquisition targets, as it shows the amount of debt the acquirer has to assume. Companies with a low EV/EBITDA multiple could be seen as attractive takeover candidates.
Another major limitation 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. In comparison, EV/EBITDA is less amenable to manipulation and can also be used to value firms that have negative net earnings but are positive on the EBITDA front.
EV/EBITDA is also a useful yardstick 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.
However, EV/EBITDA is also not without its downsides and alone can’t 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 solely banking on EV/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 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 15 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 143.6% for 2018 and a Value Score of A.
Santander Consumer USA Holdings Inc. (SC - Free Report) is a technology-driven consumer finance company focused on vehicle finance and unsecured consumer lending products. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 48.3% for 2018 and a Value Score of A. You can see the complete list of today’s Zacks #1 Rank stocks here.
Rayonier Advanced Materials Inc. (RYAM - Free Report) operates as a global supplier of cellulose specialties products, a natural polymer for the chemical industry. The stock has an expected year-over-year earnings growth rate of 124.7% for 2018. It currently has a Value Score of A and a Zacks Rank #2.
Atlas Air Worldwide Holdings, Inc. (AAWW - Free Report) is a leading provider of outsourced aircraft and aviation operating services. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 38.3% for 2018 and a Value Score of A.
UGI Corporation (UGI - Free Report) distributes, stores, transports and markets energy products and related services. The stock has expected year-over-year earnings growth rate of 20.9% for fiscal 2018. It currently has a Value Score of B and a Zacks Rank #2.
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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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