The price-to-earnings (P/E) ratio is widely considered by investors as a yardstick for evaluating the fair market value of a stock. It is preferred by many investors to handpick stocks trading at a bargain. However, even this universally used valuation multiple is not without its limitations.
Is EV/EBITDA a Better Alternative to P/E?
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 earning potential. Additionally, it has a more comprehensive approach to valuation.
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.
EBITDA, the other element, is a true reflection 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 attractive it is. A low EV/EBITDA ratio could signal that a stock is potentially undervalued and vice versa.
EV/EBITDA takes into account the debt on a company’s balance sheet that P/E ratio does not. Given 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 drawback of P/E is that it can’t be used to value a loss-making company. A company’s earnings are also subject to accounting estimates and management manipulation. EV/EBITDA, in contrast, is less amenable to manipulation and also can be used to value firms that have negative net earnings but are positive on the EBITDA side.
Moreover, EV/EBITDA allows the comparison of companies with different debt levels and is a useful tool in measuring the value of firms that are highly leveraged and have substantial depreciation and amortization expenses.
However, EV/EBITDA is also not without its shortcomings and alone cannot conclusively determine a stock’s inherent potential and future performance. The ratio varies across industries and is generally not appropriate while comparing stocks in different industries given their diverse capital spending requirements.
As such, a strategy solely based on EV/EBITDA might not yield the desired results. But you can club 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 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 10 stocks that passed the screen:
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.
Fossil Group, Inc. (FOSL - Free Report) is involved in designing, marketing and distribution of consumer fashion accessories. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 91% 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.
Principal Financial Group, Inc. (PFG - Free Report) helps people and companies around the world build, protect and advance their financial well-being through retirement, insurance and asset management solutions that suit their lives. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 6% for the current year and a Value Score of A.
GMS Inc. (GMS - Free Report) is a distributor of wallboard and suspended ceilings systems. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 10.7% for the current fiscal year and a Value Score of B.
CBIZ, Inc. (CBZ - Free Report) provides its clients with financial services including accounting, tax, financial advisory, government health care consulting, risk advisory, merger and acquisition advisory, real estate consulting and valuation services. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 11.9% 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.