Price-to-earnings (P/E), given its apparent simplicity, is the most commonly used metric in the value investing world. The ratio enjoys greater popularity among valuation metrics in the investment toolkit and is preferred while uncovering stocks trading at attractive prices. But even this straightforward, easy-to-calculate equity valuation multiple is not devoid of limitations.
What Makes EV/EBITDA a Better Choice?
While P/E is by far the most-popular valuation metric, a more-complicated metric called EV/EBITDA does a better job in working out the fair market value of a firm. Often viewed as a better substitute to P/E, this ratio offers a clearer picture of a company’s valuation and its earnings potential.
Also dubbed 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. Essentially, it is the total value of a company.
EBITDA, the other component of the ratio, gives the true picture of a company’s profitability as it eliminates 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.
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.
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 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.
However, EV/EBITDA has its limitations too. It varies across industries and is generally not appropriate while comparing stocks in different industries given their diverse capital spending requirements.
As such, a strategy entirely based on EV/EBITDA might not fetch the desired outcome. But you can club it with 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:
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 34.2% for the current year and a Value Score of A.
Hibbett Sports, Inc. (HIBB - Free Report) operates sporting goods stores in small and mid-sized markets. It offers convenient locations and a broad assortment of quality branded athletic footwear, apparel and equipment with a high level of customer service. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 24.3% for the current fiscal year. It also has a Value Score of A. You can see the complete list of today’s Zacks #1 Rank stocks here.
First Horizon National Corporation (FHN - Free Report) provides regional banking, wealth management and capital market services through its First Horizon family of companies. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 12.8% for the current year and a Value Score of B.
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.
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 41.1% 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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Disclosure: Performance information for Zacks’ portfolios and strategies are available at: https://www.zacks.com/performance.