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 attractive prices. 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, also referred to as the enterprise multiple, 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). 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, 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, as it shows the amount of debt the acquirer has to assume. Companies with a low EV/EBITDA multiple could be seen as attractive 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 tool 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 is also not without its limitations 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.
Hence, instead of solely relying on EV/EBITDA, you can club it with the other key ratios such as price-to-book (P/B), P/E and price-to-sales (P/S) to achieve the desired outcome.
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 11 stocks that passed the screen:
Verso Corporation (VRS - Free Report) makes printing papers used primarily in commercial printing, media and marketing applications. This Zacks Rank #1 stock has a Value Score of A. Earnings estimates for the company for the current year have moved up 86.2% over the past two months.
Qiwi plc (QIWI - Free Report) operates as a provider of next generation payment services primarily in Russia and the CIS. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 72.9% for the current year and a Value Score of B. You can see the complete list of today’s Zacks #1 Rank stocks here.
Newell Brands Inc. (NWL - Free Report) is a global manufacturer and marketer of consumer and commercial products. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 29.5% for the current year and a Value Score of A.
WhiteHorse Finance, Inc. (WHF - Free Report) is a business development company focused on originating loans to privately held small-cap companies across a broad range of industries. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 1.3% for the current year. It also has a Value Score of B.
Element Solutions Inc (ESI - Free Report) is a leading specialty chemicals company that offers innovative solutions to its customers across a vast spectrum of industries. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 514.3% for the current year and a Value Score of B.
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Disclosure: Performance information for Zacks’ portfolios and strategies are available at: https://www.zacks.com/performance.