The price-to-earnings (P/E) ratio is widely considered by investors as the yardstick for evaluating the fair market value of a stock. It is preferred by many investors to handpick stocks trading at a bargain. However, even this universally used valuation multiple is not without its limitations.
Is EV/EBITDA a Better Alternative to P/E?
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 referred to 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 component, is a true reflection of a company’s profitability as it removes 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.
Typically, the lower the EV/EBITDA ratio, the more attractive it is. A low EV/EBITDA ratio could signal that a stock is potentially undervalued and vice versa.
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.
Also, P/E can’t be used to value a loss-making firm. A company’s earnings are also subject to accounting estimates and management manipulation. Meanwhile, EV/EBITDA is less open to manipulation and can also be used to value companies that are making loss but are EBITDA-positive.
Moreover, EV/EBITDA is a useful tool in assessing the value of companies that are highly leveraged and have a high degree of depreciation. The ratio also 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, a strategy solely based on EV/EBITDA might not yield the desired results. But you can club it with the other major ratios in your stock investing toolbox 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 seven stocks that passed the screen:
B&G Foods, Inc. (BGS - Free Report) along with its subsidiaries manufactures, sells and distributes high quality, shelf stable, frozen food and household products. This Zacks Rank #1 stock has a Value Score of A. The company has an expected year-over-year earnings growth rate of 7.3% for the current year.
Vistra Energy Corp. (VST - Free Report) is a leading, integrated, energy company providing essential resources for customers, commerce and communities. This Zacks Rank #2 stock has expected year-over-year earnings growth of 19.8% for the current year and a Value Score of A. You can see the complete list of today’s Zacks #1 Rank stocks here.
Hilltop Holdings Inc. (HTH - Free Report) is a financial holding company. Its primary line of business is to offer business and consumer banking services. This Zacks Rank #2 stock has a Value Score of A. The company beat the Zacks Consensus Estimate for earnings in three of the trailing four quarters, the average being 41.9%.
Graphic Packaging Holding Company (GPK - Free Report) is a leading provider of paperboard packaging solutions for a wide variety of products to food, beverage and other consumer products companies. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 10.3% for the current year and a Value Score of B.
Schweitzer-Mauduit International, Inc. (SWM - Free Report) is a leading global provider of engineered solutions and advanced materials. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 5.4% for the current 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.
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Disclosure: Performance information for Zacks’ portfolios and strategies are available at: https://www.zacks.com/performance.