Price-to-earnings (P/E), given its inherent simplicity, is the most commonly used metric in the value investing world. It is preferred by many investors while handpicking stocks trading at attractive prices. However, even this straightforward, broadly used valuation metric has a few limitations.
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 earnings potential. It has a more comprehensive approach to valuation.
PBF Energy Inc. PBF, Daqo New Energy Corp. DQ, Ryder System, Inc. R, ArcBest Corporation ARCB and Tronox Holdings plc TROX are some stocks with attractive EV-to-EBITDA ratios.
What Makes EV-to-EBITDA a Better Alternative?
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 constituent of the ratio, gives a clearer picture of a company’s profitability as it removes the impact of non-cash expenses like depreciation and amortization that dampen net earnings. It is also often used as a proxy for cash flows.
Usually, 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 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 that have negative net earnings but are positive on the EBITDA front.
EV-to-EBITDA is also a useful yardstick in evaluating 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 it alone can’t 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.
As such, a strategy solely based on EV-to-EBITDA might not yield the desired results. But you can club it with the other major ratios in your stock-investing toolbox 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 our five picks out of the 22 stocks that passed the screen:
PBF Energy provides end products that comprise heating oil, transportation fuels, lubricants and many related products. This Zacks Rank #1 stock has a Value Score of A. You can see the complete list of today’s Zacks #1 Rank stocks here.
PBF Energy has an expected earnings growth rate of 764.4% for the current year. The Zacks Consensus Estimate for PBF's current-year earnings has been revised 154% upward over the past 60 days.
Daqo New Energy is a leading producer of high-purity polysilicon. This Zacks Rank #1 stock has a Value Score of A.
Daqo New Energy has an expected earnings growth rate of 160.8% for the current year. The Zacks Consensus Estimate for DQ’s current-year earnings has been revised 13.5% upward over the past 60 days.
Ryder System is one of the world's largest providers of integrated logistics and transportation solutions. This Zacks Rank #2 stock has a Value Score of A.
Ryder System has an expected earnings growth rate of 54.7% for the current year. The consensus estimate for R’s current-year earnings has been revised 3.1% upward over the past 60 days.
ArcBest provides freight transportation services and solutions. This Zacks Rank #2 stock has a Value Score of A.
ArcBest has an expected earnings growth rate of 66.4% for the current year. The Zacks Consensus Estimate for ARCB's current-year earnings has been revised 4.7% upward over the past 60 days.
Tronox is a leading producer of high-quality titanium products, including titanium dioxide pigment. This Zacks Rank #2 stock has a Value Score of A.
Tronox has an expected earnings growth rate of 42.8% for the current year. The consensus estimate for TROX’s current-year earnings has been revised 4.1% upward over the past 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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Ryder System, Inc. (R) : Free Stock Analysis Report
PBF Energy Inc. (PBF) : Free Stock Analysis Report
Tronox Holdings PLC (TROX) : Free Stock Analysis Report
DAQO New Energy Corp. (DQ) : Free Stock Analysis Report
ArcBest Corporation (ARCB) : Free Stock Analysis Report
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