The price-to-earnings (P/E) ratio is widely 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 pursuit for stocks that are trading at a bargain. But even this straightforward, easy-to-calculate multiple has a few pitfalls.
Is EV/EBITDA a Better Substitute to P/E?
While P/E enjoys great popularity, a less-used metric called EV/EBITDA gains an upper hand as it offers a clearer picture of a company’s valuation and earnings potential. EV/EBITDA, also known as the enterprise multiple, has a more complete approach to valuation as it determines a firm’s total value. P/E, on the other hand, considers only 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. In a nutshell, it is the entire value of a company.
The other constituent of the ratio, EBITDA 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.
Usually, 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 drawback 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. 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 tool in measuring 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.
Then again, EV/EBITDA has its flaws too. 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 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 true value stocks.
Screening Criteria
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 13 stocks that passed the screen:
Tech Data Corporation (NASDAQ:TECD) is one of the world's largest technology distributors. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 20.1% for the current fiscal year and a Value Score of A.
Graphic Packaging Holding Company (NYSE:GPK) 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 #1 stock has an expected year-over-year earnings growth rate of 13.3% for the current year and a Value Score of A. You can see the complete list of today’s Zacks #1 Rank stocks here.
Newell Brands Inc. (NASDAQ:NWL) is a leading global consumer goods company with a strong portfolio of well-known brands. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 36.8% for the current year and a Value Score of B.
Amkor Technology, Inc. (NASDAQ:AMKR) is a leading independent provider of semiconductor packaging and test services. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 32.7% for the current year and a Value Score of A.
Colfax Corporation (NYSE:CFX) is a global supplier of fluid handling products, including pumps, fluid handling systems and specialty valves. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 17.9% for the current year. It also has 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.
The Research Wizard is a great place to begin. It's easy to use. Everything is in plain language. And it's very intuitive. Start your Research Wizard trial today. And the next time you read an economic report, open up the Research Wizard, plug your finds in, and see what gems come out.
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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.
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Zacks Investment Research