The price/earnings ratio (P/E) is generally considered by investors as the criterion for assessing the fair market value of a stock. It is preferred by many investors while picking stocks trading at attractive prices. But even this universally used valuation multiple is not without flaws.
Although P/E enjoys great popularity among value investors, a less used and more complicated measure called EV-to-EBITDA is sometimes considered a better alternative. The EV/EBITDA ratio gives a true picture of a company’s valuation and earnings potential. It has a more global approach to evaluation.
Ethan Allen Interiors Inc. AND D, SM Energy Company SM, JAKKS Pacific, Inc. JAKK, ScanSource, Inc. SCSC and Tronox Holdings plc TROX are stocks with attractive EV/EBITDA ratios.
Is EV/EBITDA a better substitute for P/E?
EV to EBITDA is basically 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, debt, and preferred stock less cash and cash equivalents.
The other component of the multiple, EBITDA, gives a better idea of a company’s profitability because it removes the impact of non-cash expenses such as depreciation and amortization that reduce net profit. It is also often used as a cash flow indicator.
Generally, the lower the EV/EBITDA ratio, the more attractive it is. A low EV/EBITDA ratio could be a sign that a stock is potentially undervalued.
Unlike the P/E ratio, EV/EBITDA takes into account the debt on a company’s balance sheet. For this reason, it is generally used to assess potential acquisition targets. The ratio indicates the amount of debt that the acquirer must bear. Stocks with a low EV/EBITDA multiple could be seen as attractive takeover candidates.
Also, the P/E cannot be used to value a loss-making company. A company’s earnings are also subject to accounting estimates and management manipulation. In contrast, the EV/EBITDA ratio is more difficult to manipulate and can be used to assess companies that have negative net income but are positive on the EBITDA front.
The EV/EBITDA ratio is also a useful tool for assessing the value of highly leveraged and highly amortized companies. Additionally, it can be used to compare companies with different levels of debt.
But EV to EBITDA also has its limits. The ratio varies from industry to industry (a high growth industry usually has a higher multiple and vice versa) and is generally not appropriate when comparing stocks in different industries, given their needs in miscellaneous capital.
Therefore, instead of just relying on EV to EBITDA, you can combine it with the other major ratios such as price per book (P/B), P/E, and price to sales ( P/S) to achieve the desired result.
Here are the parameters to filter for value stocks:
12 Month EV-to-EBITDA – Most Recent Below Industry Median X: A lower EV/EBITDA ratio represents a cheaper valuation.
P/E using (F1) less than X-Industry Median: This metric filters out stocks that are trading at a discount to their peers.
P/B lower than the X-Industry median: A lower P/B relative to the industry average implies that the stock is undervalued.
P/S lower than the median X-Industry: The lower the P/S ratio, the more attractive the stock, as investors will have to pay a lower 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 industry median X: This metric will help select stocks that have growth rates above the industry median. This is a meaningful indicator, as decent earnings growth always adds to investor optimism.
Average volume over 20 days greater than or equal to 100,000: Adding this metric ensures that stocks can be traded easily.
Current price greater than or equal to $5: This setting will help filter out stocks that are trading at a minimum price of $5 or more.
Zacks rank less than or equal to 2: No selection is complete without the Zacks Ranking, which has been proven since its inception. It’s a fundamental truth that stocks with a Zacks #1 (Strong Buy) or 2 (Buy) ranking have always managed to overcome adversity and outperform the market.
Value score 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 most upside potential.
Here are our five picks from the 12 stocks that made it to the screen:
Ethan Allen Interiors is a leading interior design firm and manufacturer and retailer of quality home furnishings. This rank 1 stock from Zacks has a value score of A.
Ethan Allen Interiors forecasts a profit growth rate of 38.4% for the current fiscal year. The Zacks consensus estimate for ETD current-year earnings has been revised up 5.8% in the past 60 days.
SM Energy is an independent oil and gas company engaged in the exploration, exploitation, development, acquisition and production of natural gas and crude oil in North America. This Zacks #1 rank stock has a value score of A. You can see the full list of today’s Zacks #1 Rank stocks here.
SM Energy has an expected profit growth rate of 245.9% for the current year. The Zacks consensus estimate for SM earnings for the current year has been revised up 14.5% in the past 60 days.
JAKKS Pacific is a leading designer, manufacturer and marketer of toys and consumer products sold worldwide. This rank 1 action from Zacks has a value score of B.
JAKKS Pacific has an expected earnings growth rate of 8.5% for the current year. JAKK’s consensus earnings estimate for the current year has been revised upwards by 24.9% in the past 60 days.
Scan Source serves North America as a value-added distributor of specialized technologies, including automatic identification and point-of-sale products, as well as business telephony products. This rank 2 action from Zacks has a value score of A.
ScanSource forecasts a 27% profit growth rate for the current fiscal year. The Zacks consensus estimate for SCSC’s current-year earnings has been revised up 6.7% over the past 60 days.
Tronox is a leading producer of high quality titanium products including titanium dioxide pigment. This rank 2 action from Zacks has a value score of A.
Tronox forecasts a profit growth rate of 31% for the current year. TROX’s consensus earnings estimate for the current year has been revised up 7.1% in the past 60 days.
You can get the rest of the stocks on this list by signing up for your free 2-week trial to Research Assistant now and start using this screen in your own trading. Moreover, you can also create your own strategies and test them before diving into investing.
The research assistant is a great starting point. It’s easy to use. Everything is in plain language. And it’s very intuitive. Start your search assistant trial today. And the next time you’re reading an economic report, open up the research assistant, plug in your findings, and see what gems come out.
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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 the options mentioned herein. An affiliated investment adviser may hold or have shorted securities and/or hold long and/or short positions in options mentioned herein.
Disclosure: Information on the performance of Zacks portfolios and strategies is available at: https://www.zacks.com/performance.
Zacks names ‘only one best choice for doubling up’
From thousands of stocks, 5 Zacks experts have each picked their favorite to skyrocket by +100% or more in the coming months. Of these 5, Research Director Sheraz Mian selects one to have the most explosive advantage of all.
It’s a little-known chemical company that’s up 65% year-on-year, but still very cheap. With relentless demand, rising earnings estimates for 2022 and $1.5 billion for stock buybacks, retail investors could jump in at any moment.
This company could rival or surpass other recent Zacks stocks which are expected to double, such as Boston Beer Company which jumped +143.0% in just over 9 months and NVIDIA which jumped +175.9% in one. year.
Free: See our best stock and our 4 finalists >>
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JAKKS Pacific, Inc. (JAKK): Free Stock Analysis Report
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