The price-to-earnings (P/E) ratio, due to its apparent simplicity, enjoys great popularity in the value investing world and is preferred by many investors while uncovering bargain stocks. But even this widely used valuation metric is not devoid of limitations.
What Gives EV/EBITDA the Upper Hand?
While P/E is widely considered as a useful tool to work out the fair value of a stock, a more-complicated and less-used metric called EV/EBITDA is sometimes viewed as a better alternative as it offers a clearer picture of a firm’s valuation and its earnings potential. EV/EBITDA 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.
Also known as the enterprise multiple, EV/EBITDA is essentially 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 total value of a company.
The other component, EBITDA gives a clearer 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.
Typically, the lower the EV/EBITDA ratio, the more appealing it is. A low EV/EBITDA ratio could signal that a stock is undervalued.
Unlike the P/E ratio, EV/EBITDA takes debt on a company’s balance sheet into account. Due to this reason, it is typically used to value potential acquisition targets. The ratio shows the amount of debt that the acquirer has to bear. Stocks flaunting a low EV/EBITDA multiple could be seen as attractive takeover candidates.
Another key drawback of P/E is that it can’t be used to value a loss-making entity. A firm’s earnings are also subject to accounting estimates and management manipulation. In contrast, EV/EBITDA is less amenable to manipulation 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 firms with a debt-laden balance sheet and have a high degree of depreciation. It also allows the comparison of companies with different debt levels.
Then again, EV/EBITDA has its limitations too. The ratio alone can’t conclusively determine a stock’s inherent potential and its future performance. It varies across industries and is usually not appropriate while comparing stocks in different industries given their diverse capital 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 12 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 158.7% for 2018 and a Value Score of A.
Covenant Transportation Group, Inc. (CVTI - Free Report) is a truckload carrier that offers just-in-time and other premium transportation services throughout the United States. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 161.9% for 2018 and a Value Score of A. You can see the complete list of today’s Zacks #1 Rank stocks here.
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 59.8% for 2018. It has a Value Score of A.
Zions Bancorporation (ZION - Free Report) is one of the premier financial services companies in the United States. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 42.7% for 2018 and a Value Score of A.
Exelon Corporation (EXC - Free Report) is a utility services holding company. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 20% for 2018. It also has 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.