The price-to-earnings (P/E) ratio is broadly considered by investors as a yardstick for assessing the fair market value of a stock. Many prefer to take the P/E route in their quest for stocks that are trading at attractive prices. However, even this widely-popular valuation metric is not without its pitfalls.
Is EV/EBITDA a Better Substitute to P/E?
Although P/E is hands down the most widely used equity valuation ratio in the market, a relatively less-used metric called EV/EBITDA is often viewed as a better option as it offers a clearer image of a company’s valuation and earnings potential. Unlike P/E that solely considers a company’s equity portion, EV/EBITDA determines its total value.
EV/EBITDA, also known as the enterprise multiple, 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 element of the ratio, EBITDA is a true reflection of a company’s profitability as it eliminates the impact of non-cash expenses like depreciation and amortization that dilute net earnings.
Generally, 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 considers 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.
P/E also can’t be used to value a loss-making firm. A company’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 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.
However, EV/EBITDA is not devoid of limitations and it 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 spending requirements.
Hence, a strategy entirely based on EV/EBITDA might not fetch the desired results. But you can combine it with other major ratios such as price-to-book (P/B), P/E and price-to-sales (P/S) to screen bargain stocks.
Here are the parameters to screen for bargain 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:
EnPro Industries, Inc. (NPO - Free Report) is a diversified manufacturer of proprietary engineered products used in critical applications. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 62.6% for 2018 and a Value Score of B.
Domtar Corporation (UFS - Free Report) is a leading provider of a wide variety of fiber-based products, including communication, specialty and packaging papers, market pulp and absorbent hygiene products. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 73.1% for 2018. It also has a Value Score of A. You can see the complete list of today’s Zacks #1 Rank stocks here.
Unum Group (UNM - Free Report) is the industry leader in disability income protection and one of the top providers of supplemental benefits in the United States. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 21.7% for 2018 and a Value Score of A.
Popular, Inc. (BPOP - Free Report) is a diversified, publicly owned bank holding company. This Zacks Rank #2 stock has expected year-over-year earnings growth of roughly 82.8% for 2018 and a Value Score of A.
Wintrust Financial Corporation (WTFC - Free Report) is a bank holding company providing banking services, trust and investment services, commercial insurance premium financing, short-term accounts receivable financing, and certain administrative services. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 37.7% for 2018 and a Value Score of B.
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: Performance information for Zacks’ portfolios and strategies are available at: https://www.zacks.com/performance.