The price-to-earnings (P/E) ratio is by far the most widely used metric in the value investing world due to its simplicity. Many prefer to take the P/E route in their quest for stocks that are trading at attractive prices. But even this ubiquitously used equity valuation multiple is not devoid of limitations.
Is EV/EBITDA a Better Substitute to P/E?
While P/E is the most commonly used tool for evaluating a firm’s value, another valuation metric called EV/EBITDA works even better. The ratio is often viewed as a better alternative to P/E as it offers a clearer picture of a company’s valuation and earnings potential. EV/EBITDA determines the total value of a company while P/E solely 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. Simply put, it is the total value of a firm.
The other component 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 reduce net earnings. It is also often used as a proxy for cash flows.
Just like P/E, the lower the EV/EBITDA ratio, the better it is. A low EV/EBITDA ratio could be a sign 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 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. On the other hand, EV/EBITDA is difficult to manipulate and also can be used to value entities that have negative net earnings but are positive on the EBITDA front.
EV/EBITDA is also a useful yardstick in measuring the value of firms that are highly leveraged and have a high degree of depreciation. It also can be used to compare companies with different levels of debt.
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.
Thus, instead of just relying on EV/EBITDA, you can club it with the other major ratios such as price-to-book (P/B), P/E and price-to-sales (P/S) to achieve the desired results.
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 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 16 stocks that passed the screen:
SORL Auto Parts, Inc. SORL specializes in the development, production and distribution of air brake valves and hydraulic brake valves. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 58% for 2017. It has a Value Score of A.
Cosan Limited CZZ is the leading global ethanol and sugar company in terms of production with low-cost, large-scale and integrated operations in Brazil. The stock has an expected year-over-year earnings growth rate of 197% for 2017. It currently has a Value Score of A and a Zacks Rank #1. You can see the complete list of today’s Zacks #1 Rank stocks here.
American Equity Investment Life Holding Company AEL is a full service underwriter of a broad line of annuity and insurance products, with a primary emphasis on the sale of fixed rate and index annuities. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 109.8% for 2017 and a Value Score of A.
Prudential Financial, Inc. PRU is one of the largest financial services institutions in the United States, providing a wide range of insurance, investment management and other financial products and services. The stock has an expected earnings per share (EPS) growth rate of 8.5% for three to five years. It currently has a Value Score of A and a Zacks Rank #2.
Fiat Chrysler Automobiles N.V. FCAU operates as an international automotive company. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 40.8% for 2017. It has 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.
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