The price-to-earnings (P/E) ratio is broadly considered the yardstick for evaluating the fair market value of a stock. It is preferred by many investors while handpicking stocks trading at attractive prices. However, even this universally used valuation multiple is not without its limitations.
Although P/E enjoys huge 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 earnings potential. It has a more comprehensive approach to valuation.
M/I Homes, Inc. MHO, PVH Corp. PVH, Concrete Pumping Holdings, Inc. BBCP, Telefonica Brasil S.A. VIV and Ranger Energy Services, Inc. RNGR are some stocks with attractive EV-to-EBITDA ratios.
Is EV-to-EBITDA a Better Substitute to P/E?
EV-to-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 component of the multiple, gives a better idea of a company’s profitability as it removes the impact of non-cash expenses like depreciation and amortization that reduce net earnings. It is also often used as a proxy for cash flows.
Usually, the lower the EV-to-EBITDA ratio, the more appealing it is. A low EV-to-EBITDA ratio could be a sign that a stock is potentially undervalued.
However, unlike the P/E ratio, EV-to-EBITDA takes into account the debt on a company’s balance sheet. Given this reason, EV-to-EBITDA is usually used to value the 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 firm’s earnings are also subject to accounting estimates and management manipulation. In contrast, EV-to-EBITDA is harder to manipulate and can be used to value companies with negative net earnings but are positive on the EBITDA front.
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.
However, EV-to-EBITDA is not devoid of shortcomings and alone cannot conclusively determine a stock’s inherent potential and future performance. The multiple varies across industries and is usually not appropriate while comparing stocks in different industries, given their diverse capital expenditure requirements.
Therefore, instead of just relying on EV-to-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.
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 50,000: 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 our five picks out of the seven stocks that passed the screen:
M/I Homes is one of leading builders of single-family homes. This Zacks Rank #1 stock has a Value Score of B.
The Zacks Consensus Estimate for M/I Homes’s current-year earnings has been revised 11.5% upward over the last 60 days. MHO’s earnings beat the Zacks Consensus Estimate in each of the last four quarters at an average of around 30%.
PVH specializes in designing and marketing branded dress shirts, neckwear, sportswear, jeanswear, intimate apparel, swim products, footwear, handbags and related products. This Zacks Rank #2 stock has a Value Score of A. You can see the complete list of today’s Zacks #1 Rank stocks here.
PVH has an expected year-over-year earnings growth rate of 11.8% for the current year. The Zacks Consensus Estimate for PVH’s current fiscal-year earnings has been revised 13.6% upward over the past 60 days.
Concrete Pumping Holdings is a leading provider of concrete pumping and concrete waste management services in the United States and U.K. markets. This Zacks Rank #2 stock has a Value Score of A.
Concrete Pumping Holdings has an expected year-over-year earnings growth rate of 43.2% for the current year. The Zacks Consensus Estimate for BBCP’s current-year earnings has been revised 15.2% upward over the past 60 days.
Telefonica Brasil is engaged in providing communication, information and entertainment solutions in the telecommunication sector. This Zacks Rank #2 stock has a Value Score of A.
Telefonica Brasil has an expected year-over-year earnings growth rate of 10.6% for the current year. The Zacks Consensus Estimate for VIV’s current-year earnings has been revised 10.6% upward over the past 60 days.
Ranger Energy Services is a leading provider of high-specification mobile rig well services, cased-hole wireline services, and ancillary services in the U.S. oil and gas industry. This Zacks Rank #2 stock has a Value Score of A.
Ranger Energy Services has an expected year-over-year earnings growth rate of 192.1% for the current year. The Zacks Consensus Estimate for RNGR’s current-year earnings has been revised 8.2% upward over the past 60 days.
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