The price-to-earnings (P/E) ratio is broadly considered by investors as a yardstick for evaluating the fair market value of a stock. Many value investors prefer to take the P/E route in their quest for stocks that are trading at bargain prices. However, even this ubiquitously used equity valuation multiple is not devoid of limitations.
Is EV/EBITDA a Better Alternative to P/E?
While P/E enjoys significant popularity in the value investing world, a more complicated metric called EV/EBITDA gains an upper hand as it offers a clearer image 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 considers just its equity portion.
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.
EBITDA, the other constituent of the ratio, is a true reflection of a company’s profitability as it strips out 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 enticing it is. A low EV/EBITDA ratio could signal 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 downside 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 can be used to value firms that have negative net earnings but are positive on the EBITDA side.
EV/EBITDA is also a useful tool in assessing 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.
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, instead of just banking on EV/EBITDA, you can combine it with the other major ratios 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 17 stocks that passed the screen:
Genesco Inc. (GCO - Free Report) is a specialty retailer that sells footwear, headwear and accessories in retail stores in the United States and Canada. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 30.5% for the current fiscal year and a Value Score of A.
MarineMax, Inc. (HZO - Free Report) is a leading recreational boat and yacht retailer. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 17.2% 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.
Celestica Inc. (CLS - Free Report) is one of the largest electronics manufacturing services company in the world, serving the computer, and communications sectors. This Zacks Rank #1 company has an expected year-over-year earnings growth rate of 38.9% for the current year and a Value Score of B.
OFG Bancorp (OFG - Free Report) is a financial holding company that conducts its business activities through its subsidiaries. The company's products and services consist of consumer banking and lending, commercial banking, and wealth management. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 66.7% for the current year and a Value Score of A.
AdvanSix Inc. (ASIX - Free Report) is a fully-integrated producer of nylon 6 resin, chemical intermediates and ammonium sulfate fertilizer. This Zacks Rank #2 stock has expected year-over-year earnings growth of 75.9% for 2020 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.