The price-to-earnings (P/E) ratio, given its apparent simplicity, is preferred by many investors while uncovering stocks that are trading at attractive prices. A widely favored approach by value investors is to chase stocks that have a low P/E ratio. However, even this widely popular valuation metric is not without its pitfalls.
Is EV/EBITDA a Better Alternative to P/E?
While P/E enjoys huge popularity in the value investing world, a more complicated valuation metric called EV/EBITDA works even better. The ratio offers a clearer picture of a firm’s valuation and earnings potential. EV/EBITDA, also referred to as enterprise multiple, determines the total value of a firm, while P/E just considers its equity portion.
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. Simply put, it is the total value of a company.
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 reduce 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 be a sign that a stock is potentially undervalued.
However, unlike P/E ratio, EV/EBITDA takes into account 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.
Another limitation 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. On the other hand, EV/EBITDA is difficult to manipulate and also can be used to value entities 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. Moreover, it can be used to compare companies with different levels of debt.
Then again, EV/EBITDA has its flaws too. 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 just relying 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 achieve the desired results.
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:
DaVita Inc. (DVA - Free Report) is a leading provider of kidney care services in the United States. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 29.7% for the current year and a Value Score of A.
Kraton Corporation (KRA - Free Report) makes and markets biobased chemicals and specialty polymers. It is a leading global producer of styrenic block copolymers and pine chemicals. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 36.4% 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.
ADT Inc. (ADT - Free Report) provides security and automation solutions for homes and businesses primarily in the United States and Canada. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 675% for the current year and a Value Score of A.
Universal Forest Products, Inc. (UFPI - Free Report) is a holding company of businesses that combine to create one of the largest producers of wood and wood-alternative products in North America. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 19.2% for the current year and a Value Score of A.
International Game Technology PLC (IGT - Free Report) is a gaming company engaged in design, development, manufacture and marketing of casino-style gaming equipment, systems technology and game content. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 4.1% for the current year and 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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