The price-to-earnings (P/E) ratio is widely considered as a yardstick for evaluating the fair market value of a stock by investors. Many prefer to take the P/E route in pursuit of stocks that are trading at attractive prices. But even this straightforward, easy-to-calculate equity valuation multiple is not devoid of shortcomings.
Is EV/EBITDA a Better Alternative to P/E?
While P/E enjoys great popularity, a less-used and more-complicated metric called EV/EBITDA gains an upper hand as it offers a clearer image of a company’s valuation and earnings potential. EV/EBITDA, also referred to as the enterprise multiple, determines the total value of a firm while P/E just considers 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 is a true reflection of a company’s profitability as it strips out non-cash expenses like depreciation and amortization that hurt net earnings. It is also often used as a proxy for cash flows.
Generally, the lower the EV/EBITDA ratio, the more appealing it is. A low EV/EBITDA ratio could signal 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 might be considered attractive takeover candidates.
Another limitation of P/E is that it can’t be used to value a loss-making entity. A firm’s earnings are also subject to accounting estimates and management manipulation. Meanwhile, EV/EBITDA is difficult to manipulate and can also be used to value entities that have negative net earnings but are positive on the EBITDA front.
EV/EBITDA is also a useful tool in measuring the value of firms that are highly leveraged and have a high degree of depreciation. It also allows the comparison of companies with different debt levels.
Then again, EV/EBITDA has a few 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.
As such, instead of solely banking on EV/EBITDA, you can combine it with other major ratios such as price-to-book (P/B), P/E and price-to-sales (P/S) to screen true 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 22 stocks that passed the screen:
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.
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.
Patterson Companies, Inc. (PDCO - Free Report) is one of the leading distributors of dental and animal health products. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 8.6% for the current fiscal 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 6.8% for the current year and a Value Score of A.
US Foods Holding Corp. (USFD - Free Report) is a leading foodservice distributors and restaurant suppliers. This Zacks Rank #2 stock has expected year-over-year earnings growth of 13.9% for the current year and a Value Score of A.
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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.