The price-to-earnings (P/E) ratio is broadly 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 Substitute to P/E?
Although 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.
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 constituent, 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.
Generally, 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.
Unlikely P/E ratio, EV/EBITDA takes into account the debt on a company’s balance sheet. Due to this reason, EV/EBITDA is generally used to value potential acquisition targets as it shows the amount of debt the acquirer has to assume. Stocks boasting a low EV/EBITDA multiple could be seen as attractive 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.
But EV/EBITDA has its limitations too. The ratio varies across industries (a high-growth industry typically has higher multiple and vice versa) and is usually not appropriate while comparing stocks in different industries given their diverse capital 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 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:
United States Cellular Corporation (USM - Free Report) offers wireless telecommunications services in the United States. This Zacks Rank #1 stock has expected year-over-year earnings growth of 6.3% for the current year and a Value Score of A.
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 #1 stock has expected year-over-year earnings growth of 39.3% for the current year and a Value Score of B. You can see the complete list of today’s Zacks #1 Rank stocks here.
Diamond S Shipping Inc. (DSSI - Free Report) provides seaborne transportation of crude oil, refined petroleum and other products in international shipping markets. This Zacks Rank #2 stock has expected year-over-year earnings growth of 1,150% for the current year and a Value Score of A.
AZZ Inc. (AZZ - Free Report) is a global provider of metal coating services, welding solutions, specialty electrical equipment and highly engineered services. This Zacks Rank #2 stock has expected year-over-year earnings growth of 4.4% for the current fiscal year and a Value Score of A.
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 #2 company has an expected year-over-year earnings growth rate of 14.8% for the current year 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: 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.