The price-to-earnings (P/E) ratio is by far the most widely used metric in the value investing world 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 has a few pitfalls.
EV/EBITDA is a Better Alternative, But Why?
Although 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.
EBITDA, the other component, gives a clearer picture of a company’s profitability as it eliminates the impact of non-cash expenses like depreciation and amortization that dilute net earnings. It is also often used as a proxy for cash flows.
Typically, the lower the EV/EBITDA ratio, the more enticing it is. A low EV/EBITDA ratio could be a sign that a stock is undervalued.
EV/EBITDA takes into account the debt on a company’s balance sheet that P/E ratio does not. Due to 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.
Another downside of P/E is that it can’t be used to value a loss-making entity. 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.
EV/EBITDA is also a useful yardstick in measuring the value of firms that are highly leveraged and have a high degree of depreciation. It also can be used to compare companies with different levels of debt.
But 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.
Thus, 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:
Altra Industrial Motion Corp. (AIMC - Free Report) is a designer, producer and marketer of electromechanical power transmission products. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 23.9% for 2018 and a Value Score of B.
Regal Beloit Corporation (RBC - Free Report) is a leading manufacturer of electrical and mechanical motion control and power generation products serving markets throughout the world. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 21.6% for 2018 and a Value Score of A. You can see the complete list of today’s Zacks #1 Rank stocks here.
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 39.4% for 2018 and a Value Score of A.
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 143.6% for 2018 and a Value Score of A.
Capital One Financial Corporation (COF - Free Report) is a financial holding company that offers a broad spectrum of financial products and services to consumers, small businesses and commercial clients through a variety of channels. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 57.7% for 2018. It has a Value Score of A.
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.