The price-to-earnings (P/E) multiple enjoys wide-scale popularity among investors seeking stocks trading at a bargain. In addition to being a widely-used tool for screening stocks, P/E is a popular metric to work out the fair market value of a firm. But even this ubiquitously used valuation multiple has a few downsides.
Although P/E is the most popular valuation metric, a more complicated multiple called EV-to-EBITDA works even better. Often considered a better alternative to P/E, it gives the true picture of a company’s valuation and earning potential, and has a more complete approach to valuation. While P/E considers a firm’s equity portion, EV-to-EBITDA determines its total value.
Jackson Financial Inc. JXN, AAR Corp. AIR, Core & Main, Inc. CNM, Aegon N.V. AEG and Cowen Inc. COWN are some stocks with impressive EV-to-EBITDA ratios.
Is EV-to-EBITDA a Better Substitute to P/E?
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, its debt and preferred stock minus cash and cash equivalents.
The other component of the multiple, EBITDA, 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.
Typically, the lower the EV-to-EBITDA ratio, the more attractive it is. A low EV-to-EBITDA ratio could signal that a stock is potentially undervalued.
EV-to-EBITDA takes into account the debt on a company’s balance sheet that the P/E ratio does not. Due to this reason, EV-to-EBITDA is generally used to value the potential acquisition targets as it shows the amount of debt the acquirer has to assume. Stocks boasting a low EV-to-EBITDA multiple could be seen as attractive takeover candidates.
Another shortcoming of P/E is that it can’t be used to value a loss-making firm. A company’s earnings are also subject to accounting estimates and management manipulation. On the other hand, EV-to-EBITDA is difficult to manipulate and can also be used to value companies making losses but are EBITDA-positive.
EV-to-EBITDA is also a useful yardstick for 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.
But EV-to-EBITDA has its limitations too. The ratio varies across industries (a high-growth industry typically has a higher multiple and vice versa) and is usually not appropriate while comparing stocks in different industries, given their diverse capital requirements.
Hence, a strategy entirely based on EV-to-EBITDA might not yield the desired results. 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 bargain stocks.
Here are the parameters to screen for bargain 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 nine stocks that passed the screen:
Jackson Financial is a financial services company offering a diverse suite of annuities to retail investors in the United States. This Zacks Rank #1 stock has a Value Score of A.
Jackson Financial has an expected earnings growth rate of 20.3% for 2023. The Zacks Consensus Estimate for JXN’s 2023 earnings has been revised 6.3% upward over the past 60 days.
AAR provides various products and services to the aviation and defense industries worldwide. AIR, a Zacks Rank #1 stock, has a Value Score of B. You can see the complete list of today’s Zacks #1 Rank stocks here.
AAR has an expected year-over-year earnings growth rate of 27.3% for fiscal 2023. The Zacks Consensus Estimate for AIR’s fiscal 2023 earnings has been revised 2.4% upward over the last 60 days.
Core & Main is a leading specialized distributor of water, wastewater, storm drainage and fire protection products, and related services. This Zacks Rank #2 stock has a Value Score of A.
Core & Main has an expected year-over-year earnings growth rate of 159% for the current fiscal year. The consensus estimate for CNM’s current fiscal-year earnings has been revised 10.8% upward over the last 60 days.
Aegon is an integrated international financial services group offering investment, protection and retirement solutions. This Zacks Rank #2 stock has a Value Score of A.
Aegon has an expected year-over-year earnings growth rate of 1,625% for 2023. The Zacks Consensus Estimate for AEG’s 2023 earnings has been revised 1.5% upward over the last 60 days.
Cowen provides investment banking, equity research, sales and trading, prime brokerage, global clearing, commission management services and actively managed alternative investment products globally. This Zacks Rank #2 stock has a Value Score of A.
Cowen has an expected earnings growth rate of 69.8% for 2023. The consensus estimate for COWN’s 2023 earnings has been revised 0.2% upward over the past 60 days.
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