Price-to-earnings (P/E), without a shadow of a doubt, is the most popular metric used by investors to work out the fair value of a stock. Many prefer to take the P/E route in their quest for stocks that are trading at a discount. But even this universally used valuation multiple is not without its flaws.
Why EV/EBITDA is a Better Choice?
Although P/E enjoys great popularity among value investors, a more complicated metric called EV/EBITDA is sometimes viewed as a better alternative. EV/EBITDA gives the true picture of a company’s valuation and its earning potential. Moreover, it has a more complete approach to valuation.
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). The first constituent of the ratio, EV, is a firm’s market capitalization plus the market value of its debt and preferred equity minus cash.
The other element of the ratio, EBITDA, is a true reflection of a company’s profitability as it eliminates non-cash expenses like depreciation and amortization that dilute net earnings. It is also often used as a proxy for cash flows.
Just like P/E, the lower the EV/EBITDA ratio, the more appealing it is. A low EV/EBITDA ratio could imply that a stock is potentially undervalued and vice versa.
While P/E just considers a firm’s equity portion, EV/EBITDA determines its total value. Unlike the P/E ratio, EV/EBITDA takes debt on a company’s balance sheet into consideration. This is also the reason why EV/EBITDA is commonly used to value likely acquisition targets. The ratio shows the amount of debt that the acquirer has to bear. Stocks with a low EV/EBITDA multiple could be seen as attractive takeover candidates.
Another flaw 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 harder to manipulate and can also be used to value companies that have negative net earnings but are positive on the EBITDA front.
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 also not without its shortcomings and it alone can’t conclusively determine a stock’s inherent potential and its future performance. The multiple varies across industries (a high-growth industry typically has higher multiple) and is generally not appropriate for comparing stocks in different industries due to their diverse capital requirements.
Thus, a strategy solely based on EV/EBITDA might not fetch the desired outcome. But you can combine it with the other major ratios in your stock investing toolbox such as price-to-book (P/B), P/E and price-to-sales (P/S) to uncover value stocks.
Here are the parameters to screen for true 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 14 stocks that passed the screen:
The Mosaic Company (MOS - Free Report) is one of the world's leading crop nutrition companies. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 23.7% for the current year and a Value Score of B.
Korea Electric Power Corporation (KEP - Free Report) generates and supplies electric power to its customers, both industrial and residential. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 204.4% for the current year. It also has a Value Score of A. You can see the complete list of today’s Zacks #1 Rank stocks here.
BBX Capital Corporation (BBX - Free Report) is involved in the acquisition, ownership and management of joint ventures and investments in real estate and real estate development projects and middle market operating businesses. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 25% for the current year. It also has a Value Score of A.
Genesco Inc. (GCO - Free Report) is a specialty retailer that sells footwear, headwear and accessories in retail stores in the United States and Canada. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 4.1% for the current fiscal year and a Value Score of B.
Textron Inc. (TXT - Free Report) is one of the world’s best-known multi-industry companies that leverages its global network of aircraft, defense, industrial and finance businesses to provide customers with innovative products and services. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 8.4% for the current year 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.