Value investors are generally fixated on the price-to-earnings (P/E) multiple while seeking stocks that are trading at a bargain. P/E, without a shadow of doubt, is the most popular multiple used by investors to evaluate the fair market value of a stock. But even this widely-popular valuation metric is not without its pitfalls.
EV-to-EBITDA is a Better Approach, Here’s Why
Although P/E is preferred by many investors to uncover value stocks, another valuation metric called EV-to-EBITDA does a better job. The ratio is sometimes viewed as a superior substitute as it offers a clearer picture of a firm’s valuation and its earnings potential. EV-to-EBITDA has a more comprehensive approach to valuation as it determines a firm’s total value. In contrast, P/E just considers the equity portion of a firm.
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, debt and preferred stock minus cash and cash equivalents. The other constituent of the ratio, 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. Usually, the lower the EV-to-EBITDA ratio, the more appealing it is. A low EV-to-EBITDA ratio could signal that a stock is potentially undervalued. However, unlike P/E ratio, EV-to-EBITDA takes into account the debt on a company’s balance sheet. For this reason, EV-to-EBITDA is usually used to value the possible acquisition targets. Stocks with a low EV-to-EBITDA multiple could be seen as potential 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 that are making loss but are EBITDA-positive. EV-to-EBITDA is also a useful yardstick in assessing 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 downsides too. It varies across industries and is generally not appropriate while comparing stocks in different industries given their diverse capital spending requirements. Therefore, instead of just relying on EV-to-EBITDA, you can club it with the other major ratios such as price-to-book (P/B), P/E and price-to-sales (P/S) to achieve the desired results. Screening Criteria
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. 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. Value Score of less than or equal to B: Here are five of the 20 stocks that passed the screen: The ODP Corporation ( ODP Quick Quote ODP - Free Report) is one of the leading providers of business services and supplies, products and technology solutions to small, medium and enterprise businesses. This Zacks Rank #1 stock has expected year-over-year earnings growth of 11% for the current year and a Value Score of A. United Natural Foods, Inc. ( UNFI Quick Quote UNFI - Free Report) is a leading distributor of natural, organic and specialty food and non-food products in the United States and Canada. This Zacks Rank #1 stock has expected year-over-year earnings growth of 26.5% for the current fiscal year and a Value Score of B. You can see . the complete list of today’s Zacks #1 Rank stocks here Covenant Logistics Group, Inc. ( CVLG Quick Quote CVLG - Free Report) , together with its subsidiaries, offers a portfolio of transportation and logistics services. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 82% for the current year and a Value Score of A. Boise Cascade Company ( BCC Quick Quote BCC - Free Report) operates as a wood products manufacturer and building materials distributor. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 145% for the current year and a Value Score of A. Mr. Cooper Group Inc. ( COOP Quick Quote COOP - Free Report) provides quality servicing, origination and transaction-based services principally to single-family residences in the United States. This Zacks Rank #2 stock has expected year-over-year earnings growth of 154.5% for the current year and a Value Score of B. You can get the rest of the stocks on this list by signing up now for your 2-week free trial to the Research Wizard and start using this screen in your own trading. Further, you can also create your own strategies and test them first before taking the investment plunge. The Research Wizard is a great place to begin. It's easy to use. Everything is in plain language. And it's very intuitive. Start your Research Wizard trial today. And the next time you read an economic report, open up the Research Wizard, plug your finds in, and see what gems come out. . Click here to sign up for a free trial to the Research Wizard today 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 options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. Disclosure: Performance information for Zacks’ portfolios and strategies are available at: . https://www.zacks.com/performance