Investors typically have a fixation on the price-to-earnings (P/E) multiple while seeking 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. But even this straightforward, broadly used valuation metric suffers a few downsides.
What Makes EV/EBITDA a Better Substitute?
The popularity of P/E can be attributed to its apparent simplicity. While it is the most commonly used tool for assessing a firm’s value, a more complicated metric called EV/EBITDA does a better job. Also referred to as enterprise multiple, EV/EBITDA offers a clearer picture of a company’s valuation and its earnings potential. While P/E just considers a firm’s equity portion, EV/EBITDA determines its total value.
EV/EBITDA is 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.
The other component of the multiple, EBITDA gives a clearer picture of a company’s profitability as it eliminates the impact of non-cash expenses like depreciation and amortization that dilute net earnings. It is also often used as a proxy for cash flows.
Generally, the lower the EV/EBITDA ratio, the more attractive it is. A low EV/EBITDA ratio could signal that a stock is potentially undervalued.
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 shortcoming of P/E is that it can’t be used to value a loss-making firm. A company’s earnings are also subject to accounting estimates and management manipulation. In contrast, EV/EBITDA is less open to manipulation 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 that are highly leveraged and have a high degree of depreciation. Moreover, the ratio allows the comparison of companies with different debt levels.
Then again, EV/EBITDA has its shortcomings 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, a strategy only based on EV/EBITDA might not fetch the desired results. But you can club it with other key ratios such as price-to-book (P/B), P/E and price-to-sales (P/S) to screen 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 15 stocks that passed the screen:
Newell Brands Inc. (NWL - Free Report) is a global manufacturer and marketer of consumer and commercial products. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 25.6% for the current year and a Value Score of A.
AZZ Inc. (AZZ - Free Report) is a global provider of metal coating services, welding solutions, specialty electrical equipment and highly engineered services. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 37.8% for the current fiscal year. It also has a Value Score of B. You can see the complete list of today’s Zacks #1 Rank stocks here.
Synnex Corporation (SNX - Free Report) is a business process services company, which provides business-to-business services that help their customers and business partners grow and enhance their customer-engagement strategies. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 15.8% for the current fiscal year and a Value Score of A.
Vitamin Shoppe, Inc. (VSI - Free Report) is a specialty retailer and direct marketer of nutritional products. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 111.5% 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 11.1% for the current fiscal 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.
The Research Wizard is a great place to begin. It's easy to use. Everything is in plain language. And it's very intuitive. Start your Research Wizard trial today. And the next time you read an economic report, open up the Research Wizard, plug your finds in, and see what gems come out.
Click here to sign up for a free trial to the Research Wizard today.
Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.
Disclosure: Performance information for Zacks’ portfolios and strategies are available at: https://www.zacks.com/performance.