The price-to-earnings (P/E) ratio is the most commonly used tool for evaluating a firm's value due to its simplicity. A widely favored approach by value investors is to chase for stocks that have a low P/E ratio. However, even this broadly used valuation multiple is not without its shortcomings. Why EV/EBITDA is a Better Choice?
Although P/E enjoys great popularity among value investors, a more complicated metric called EV/EBITDA is sometimes viewed as a better alternative. EV/EBITDA gives the true picture of a company's valuation and earning potential. Additionally, it has a more comprehensive approach to valuation.
EV/EBITDA is essentially the enterprise value (EV) of a stock divided by its earnings before interest, taxes, depreciation and amortization (EBITDA). The first constituent of the ratio, EV, is a firm's market capitalization plus the market value of its debt and preferred equity minus cash.
EBITDA, the other element of the ratio, is a true reflection of a company's profitability as it removes the impact of non-cash expenses like depreciation and amortization that depress ne t earnings
. It is also often used as a proxy for cash flows.
Just like P/E, the lower the EV/EBITDA ratio, the more appealing it is. A low EV/EBITDA ratio could imply that a stock is potentially undervalued and vice versa.
EV/EBITDA takes into account the debt on a company's balance sheet that P/E ratio does not. Given 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.
Moreover, 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. In contrast, 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 with a debt-laden balance sheet and have a high degree of depreciation. It also allows the comparison of companies with different debt levels.
But EV/EBITDA is not without its limitations. 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.
Thus, instead of solely relying 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 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 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 14 stocks that passed the screen: Quanta Services, Inc. PWR
is a leading specialized contracting services company, delivering infrastructure solutions for the electric power, oil and gas and communications industries. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 25.3% for the current year and a Value Score of B. Chaparral Energy, Inc. CHAP
engages in the oil and natural gas exploration and production. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 41.9% for the current year and a Value Score of A. You can see the complete list of today's Zacks #1 Rank stocks here
. DXC Technology Company DXC
is an IT services company. Its services include analytics, application, business process, security, consulting, enterprise and cloud applications. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 3.9% for the current fiscal year and a Value Score of A. TOTAL S.A. TOT
operates as an integrated oil and gas company globally. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 4.8% for the current year and a Value Score of A. Principal Financial Group, Inc. PFG
helps people and companies around the world build, protect and advance their financial well-being through retirement, insurance and asset management solutions that fit their lives. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 0.9% 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.
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. Click here to sign up for a free trial to the Research Wizard today
. 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 .
Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free report Quanta Services, Inc. (PWR): Free Stock Analysis Report Principal Financial Group, Inc. (PFG): Free Stock Analysis Report TOTAL S.A. (TOT): Free Stock Analysis Report DXC Technology Company. (DXC): Free Stock Analysis Report Chaparral Energy, Inc. (CHAP): Free Stock Analysis Report To read this article on Zacks.com click here. Zacks Investment Research