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 attractive prices. However, even this universally used valuation multiple is not without its limitations.
Why EV-to-EBITDA is a Better Substitute?
While P/E enjoys great popularity among value investors, a less-used and more-complicated metric called EV-to-EBITDA is sometimes viewed as a better alternative. EV-to-EBITDA gives the true picture of a company’s valuation and earning potential. It has a more comprehensive approach to valuation.
Also dubbed as the enterprise multiple, EV-to-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, debt and preferred stock minus cash and cash equivalents.
The other component of the multiple, EBITDA, gives a clearer picture 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.
Just like P/E, the lower the EV-to-EBITDA ratio, the more attractive it is. A low EV-to-EBITDA ratio could be a sign that a stock is potentially undervalued.
However, unlike P/E ratio, EV-to-EBITDA takes into account the debt on a company’s balance sheet. For this reason, EV-to-EBITDA is usually used to value possible acquisition targets. Stocks with a low EV-to-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. In contrast, EV-to-EBITDA is less amenable to manipulation and can also be used to value companies that are making loss but are EBITDA-positive.
EV-to-EBITDA is also a useful tool in measuring the value of firms that are highly leveraged and have a high degree of depreciation. Moreover, it can be used to compare companies with different levels of debt.
Then again, EV-to-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.
Thus, a strategy entirely based on EV-to-EBITDA might not fetch the desired outcome. But you can club it with other major ratios 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-to-EBITDA 12 Months-Most Recent less than X-Industry Median: A lower EV-to-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 18 stocks that passed the screen:
Qiwi plc QIWI operates as a provider of next-generation payment services primarily in Russia and the CIS. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 11.6% for the current year and a Value Score of B.
Cowen Inc. COWN through its operating subsidiaries, provides investment banking, research, sales and trading, prime brokerage, global clearing, investment management and commission management services. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 195.5% for the current year and a Value Score of B. You can see the complete list of today’s Zacks #1 Rank stocks here.
Big Lots, Inc. BIG, through its fully owned subsidiaries, is a discount retailer operating in the United States. This Zacks Rank #2 stock has expected year-over-year earnings growth of 85.6% for the current fiscal year and a Value Score of A.
SpartanNash Company SPTN distributes grocery products to a diverse group of independent and chain retailers, its corporate-owned retail stores, and U.S. military commissaries and exchanges. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 129.1% for the current year and a Value Score of A.
Principal Financial Group, Inc. PFG is a leader in global investment management, offering businesses, individuals and institutional clients a wide range of financial products and services. This Zacks Rank #2 stock has a Value Score of A. The Zacks Consensus Estimate for the current year has been revised 4.6% upward over the last 60 days.
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.
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Big Lots, Inc. (BIG) : Free Stock Analysis Report
Principal Financial Group, Inc. (PFG) : Free Stock Analysis Report
Cowen Group, Inc. (COWN) : Free Stock Analysis Report
SpartanNash Company (SPTN) : Free Stock Analysis Report
QIWI PLC (QIWI) : Free Stock Analysis Report
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