Understanding Stock Valuation: Why EV-to-EBITDA Might Be Your Best Tool

Investors often focus on the price-to-earnings (P/E) ratio to find bargain stocks. This metric helps in screening stocks and estimating a company’s fair market value. However, the P/E ratio does have some limitations.

While P/E is a familiar metric, a more complex measure known as EV-to-EBITDA can offer a clearer evaluation of a company’s overall value and earnings potential. Unlike P/E, which looks at equity, EV-to-EBITDA assesses a company’s 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) stand out as stocks with appealing EV-to-EBITDA ratios.

Comparing EV-to-EBITDA with P/E

The EV-to-EBITDA ratio is calculated by dividing a stock’s enterprise value (EV) by its earnings before interest, taxes, depreciation, and amortization (EBITDA). EV captures a company’s market cap, debt, and preferred stock, subtracting cash and equivalents. EBITDA, on the other hand, offers a clearer view of profitability by excluding non-cash expenses that can impact net earnings. It is often treated as a proxy for cash flow.

A lower EV-to-EBITDA ratio is more attractive, suggesting a stock may be undervalued. This metric includes debt on a company’s balance sheet, unlike P/E, making it particularly useful for evaluating potential acquisition targets. Stocks with low EV-to-EBITDA ratios can also be seen as appealing candidates for takeovers.

Another downside of P/E is its inability to assess loss-making firms. Earnings can be influenced by accounting methods and management choices, while EV-to-EBITDA provides a more stable measure that applies to companies that may not yet be profitable but do post positive EBITDA. This metric is also beneficial when comparing companies with varying debt levels.

However, EV-to-EBITDA has its own weaknesses. The ratio can differ greatly between industries—high-growth sectors typically show higher multiples. Thus, it may not be suitable for direct comparisons across sectors due to their different capital structures.

Investors should not rely solely on EV-to-EBITDA. It works well when combined with other significant ratios like price-to-book (P/B), P/E, and price-to-sales (P/S) when screening for value stocks.

Criteria for Screening Value Stocks

Below are the key metrics to consider when screening for value stocks:

EV-to-EBITDA 12 Months-Most Recent less than X-Industry Median: A lower ratio indicates a cheaper valuation.

P/E using (F1) less than X-Industry Median: Identifies stocks trading at a discount compared to peers.

P/B less than X-Industry Median: A lower P/B suggests the stock could be undervalued.

P/S less than X-Industry Median: A smaller P/S ratio makes a stock more attractive, as it indicates a lower price for the same sales.

Estimated One-Year EPS Growth F(1)/F(0) greater than or equal to X-Industry Median: This filters stocks with growth rates that surpass the industry average.

Average 20-day Volume greater than or equal to 50,000: This ensures adequate liquidity for trading shares.

Current Price greater than or equal to $5: This filters for stocks priced at $5 or higher.

Zacks Rank less than or equal to 2: Stocks rated #1 (Strong Buy) or #2 (Buy) have historically outperformed the market.

Value Score of less than or equal to B: Research shows stocks with a Value Score of A or B, coupled with a Zacks Rank of #1 or #2, offer solid upside potential.

Here are five attractive stock picks based on this screening:

Nomad Foods is a notable player in the frozen food sector, operating mainly in Europe. With a Zacks Rank of #2 and a Value Score of A, it shows strong momentum with a projected earnings growth of 12.6% year-over-year for 2024, and the Zacks Consensus Estimate for its earnings has increased by 1% recently.

El Pollo Loco operates quick-service restaurants and also has a Zacks Rank of #2 and a Value Score of A. Its projected earnings growth rate for 2024 stands at 14.1%, with a recent upward adjustment of 1.3% in earnings estimates.

KB Home is a recognized name in U.S. homebuilding. It has a Zacks Rank of #2 and a Value Score of A, forecasting a 20% earnings growth for fiscal 2024, with a slight earnings estimate revision upward by 0.5%.

Columbia Banking System offers diverse banking services and maintains a Zacks Rank of #2 with a Value Score of B. Its earnings projections for 2024 have risen by 2%, while the firm recently exceeded earnings estimates in three of the last four quarters.

Pampa Energia is a leading energy company in Argentina, boasting a Zacks Rank of #2 and a Value Score of A. Its predicted earnings growth rate is an impressive 57.3% for 2024, achieving substantial earnings surprises in recent quarters.

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Disclosure: Officers, directors, and employees of Zacks Investment Research may own, have sold short, or hold various positions in the securities mentioned.

Further details on Zacks’ performance metrics are available at: https://www.zacks.com/performance.

Top Stock Selection by Research Chief

Out of thousands of stocks available, five Zacks experts have identified their top picks poised to improve by 100% or more in the coming months. Among these, Director of Research Sheraz Mian has highlighted one stock predicted to have the most significant upside.

This company targets younger audiences, generating nearly $1 billion in revenue last quarter. The recent stock price dip presents an ideal entry point for investors. Though investment carries risks, this stock may outperform earlier Zacks predictions like Nano-X Imaging which saw a 129.6% increase within nine months.

Download Our Free Report to See Top Stock Picks and Recommendations!

Pampa Energia S.A. (PAM): Free Stock Analysis Report

KB Home (KBH): Free Stock Analysis Report

Columbia Banking System, Inc. (COLB): Free Stock Analysis Report

El Pollo Loco Holdings, Inc. (LOCO): Free Stock Analysis Report

Nomad Foods Limited (NOMD): Free Stock Analysis Report

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The views and opinions expressed herein are those of the author and do not necessarily reflect those of Nasdaq, Inc.