Investors generally tend to cling to the price-to-earnings (P/E) metric while looking for bargain stocks. In addition to being a widely used tool for screening stocks, P/E is also a popular metric to work out the fair market value of a company. But even this ubiquitously used valuation multiple has a few downsides.
While 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 earnings 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.
Nomad Foods Limited NOMD, El Pollo Loco Holdings, Inc. LOCO, KB Home KBH, Columbia Banking System, Inc. COLB and Pampa Energia S.A. PAM 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, debt and preferred stock minus cash and cash equivalents. EBITDA, the other component, 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.
The lower the EV-to-EBITDA ratio, the more appealing it is. A low EV-to-EBITDA ratio indicates that a stock is potentially undervalued. EV-to-EBITDA takes into account the debt on a company’s balance sheet, which the P/E ratio does not. For this reason, EV-to-EBITDA is generally used to value 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 loss-making but EBITDA-positive companies. 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. It can also 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.
A strategy solely based on EV-to-EBITDA might not yield the desired results. 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.
Screening Criteria
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.
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: 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 six stocks that passed the screen:
Nomad Foods manufactures and distributes frozen foods primarily in the United Kingdom, Italy, Germany, Sweden, France and Norway. This Zacks Rank #2 stock has a Value Score of A.
Nomad Foods has an expected year-over-year earnings growth rate of 12.6% for 2024. The Zacks Consensus Estimate for NOMD’s 2024 earnings has been revised 1% upward over the past 60 days.
El Pollo Loco develops, franchises, licenses and operates quick-service restaurants under the name El Pollo Loco. 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.
El Pollo Loco has an expected year-over-year earnings growth rate of 14.1% for 2024. The Zacks Consensus Estimate for LOCO’s 2024 earnings has been revised 1.3% upward over the past 60 days. KB Home is one of the largest and most recognized homebuilders in the United States. This Zacks Rank #2 stock has a Value Score of A.
KB Home has an expected year-over-year earnings growth rate of 20% for fiscal 2024. The Zacks Consensus Estimate for KBH’s fiscal 2024 earnings has been revised 0.5% upward over the past 60 days.
Columbia Banking System is a registered financial holding company, providing a broad range of banking, private banking, mortgage, and other financial services to corporate, institutional, small business and individual customers. This Zacks Rank #2 stock has a Value Score of B.
The consensus estimate for Columbia Banking System’s 2024 earnings has been revised 2% upward over the past 60 days. COLB’s earnings beat the Zacks Consensus Estimate in three of the last four quarters while missing it once. In this time frame, it delivered an earnings surprise of roughly 2.1%, on average.
Pampa Energia is a leading independent energy-integrated company in Argentina. This Zacks Rank #2 stock has a Value Score of A.
Pampa Energia has an expected year-over-year earnings growth rate of 57.3% for 2024. PAM beat the Zacks Consensus Estimate in three of the last four quarters while missing once. In this time frame, it has delivered an earnings surprise of roughly 62%, on average.
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