Price-to-earnings (P/E), due to 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 universally used valuation multiple is not without its limitations.
What Makes EV/EBITDA a Better Substitute?
While P/E is hands down the most widely used equity valuation ratio in the market, a relatively less used metric called EV/EBITDA is often viewed as a better option as it offers a clearer picture of a company’s valuation and earnings potential. Unlike P/E that solely considers a company’s equity portion, EV/EBITDA determines its total value.
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.
EBITDA, the other element, gives the true picture of a company’s profitability as it removes the impact of non-cash expenses like depreciation and amortization that depress net earnings.
Usually, 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.
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 evaluating the value of firms that are highly leveraged and have a high degree of depreciation. It can also be used to compare companies with different levels of debt.
Then again, EV/EBITDA has its flaws. 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.
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 12 stocks that passed the screen:
Lincoln National Corporation (LNC - Free Report) is a diversified life insurance and investment management company. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 133.8% for the current year. It also has a Value Score of A.
Amkor Technology, Inc. (AMKR - Free Report) is one of the largest providers of semiconductor packaging and test services. This Zacks Rank #1 company has an expected year-over-year earnings growth rate of 78.6% for the current year and a Value Score of A. You can see the complete list of today’s Zacks #1 Rank stocks here.
US Foods Holding Corp. (USFD - Free Report) is a leading foodservice distributors and restaurant suppliers. This Zacks Rank #1 stock has expected year-over-year earnings growth of 12.2% for the current year and a Value Score of B.
Donnelley Financial Solutions, Inc. (DFIN - Free Report) is a leader in risk and compliance solutions, offering insightful technology, industry expertise and data insights to clients globally. This Zacks Rank #2 stock has expected year-over-year earnings growth of 20.6% for the current year and a Value Score of A.
Empire State Realty Trust, Inc. (ESRT - Free Report) is a leading real estate investment trust. This Zacks Rank #2 company has an expected year-over-year earnings growth rate of 4.2% for the current year and a Value Score of B.
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