Pick These 5 Value Stocks With Alluring EV/EBITDA Ratios

The price-to-earnings (P/E) ratio is widely considered as a yardstick for evaluating the fair market value of a stock by investors. Many prefer to take the P/E route in pursuit of stocks that are trading at attractive prices. But even this straightforward, easy-to-calculate equity valuation multiple is not devoid of shortcomings.

Is EV/EBITDA a Better Alternative to P/E?

While P/E enjoys great popularity, a less-used and more-complicated metric called EV/EBITDA gains an upper hand as it offers a clearer image of a company’s valuation and earnings potential. EV/EBITDA also referred to as the enterprise multiple determines the total value of a firm while P/E just considers its equity portion.

EV/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.

EBITDA is a true reflection of a company’s profitability as it strips out non-cash expenses like depreciation and amortization that hurt net earnings. It is also often used as a proxy for cash flows.

Generally, the lower the EV/EBITDA ratio, the more appealing it is. A low EV/EBITDA ratio could signal that a stock is potentially undervalued.  

However, EV/EBITDA takes into account the debt on a company’s balance sheet that P/E ratio does not. Given this reason, EV/EBITDA is usually used to value possible acquisition targets, as it shows the amount of debt the acquirer has to assume. Companies with a low EV/EBITDA multiple might be considered attractive takeover candidates.

Another limitation of P/E is that it can’t be used to value a loss-making entity. A firm’s earnings are also subject to accounting estimates and management manipulation. Meanwhile, EV/EBITDA is difficult to manipulate and can also be used to value entities that have negative net earnings but are positive on the EBITDA front.

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