Investors generally have a fixation on the price-to-earnings (P/E) multiple while seeking stocks that are trading at a bargain. A widely favored approach by value investors is to chase stocks that have a low P/E ratio. However, even this widely popular valuation metric is not without its pitfalls.
While P/E is hands down the most widely used equity valuation ratio in the market, a relatively less used metric called EV-to-EBITDA is often viewed as a better option as it offers a clearer picture of a company’s valuation and earnings potential. Unlike P/E that solely considers a company’s equity portion, EV-to-EBITDA determines its total value. Plains GP Holdings, L.P. ( PAGP Quick Quote PAGP - Free Report) , GMS Inc. ( GMS Quick Quote GMS - Free Report) , Motorcar Parts of America, Inc. ( MPAA Quick Quote MPAA - Free Report) , MDU Resources Group, Inc. ( MDU Quick Quote MDU - Free Report) and VMware, Inc. ( VMW Quick Quote VMW - Free Report) are some stocks with alluring EV-to-EBITDA ratios. EV-to-EBITDA is a Better Approach, Here’s Why
Also referred to as the enterprise multiple, 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, its debt and preferred stock minus cash and cash equivalents.
EBITDA, the other element, 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. Just like P/E, the lower the EV-to-EBITDA ratio, the more appealing it is. A low EV-to-EBITDA ratio could be a sign that a stock is potentially undervalued. EV-to-EBITDA takes into account the debt on a company’s balance sheet that P/E ratio does not. Given 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 tool in measuring the value of firms that are highly leveraged and have a high degree of depreciation. Moreover, it can be used to compare companies with different levels of debt. However, EV-to-EBITDA is also not without its shortcomings and alone cannot conclusively determine a stock’s inherent potential and future performance. The ratio varies across industries and is generally not appropriate while comparing stocks in different industries, given their diverse capital spending requirements. As such, a strategy solely based on EV-to-EBITDA might not yield the desired results. But 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 bargain stocks. 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 12 stocks that passed the screen: Plains GP Holdings, through its subsidiaries, is involved in the transportation, storage, terminalling, and marketing of crude oil and refined products. This Zacks Rank #1 stock has a Value Score of A. Plains GP Holdings has an expected year-over-year earnings growth rate of 258.3% for the current year. The Zacks Consensus Estimate for PAGP's current-year earnings has been revised 32% upward over the past 60 days. GMS is a distributor of wallboard and suspended ceilings systems. This Zacks Rank #1 stock has a Value Score of B. You can see . the complete list of today’s Zacks #1 Rank stocks here GMS has an expected year-over-year earnings growth rate of 100.6% for the current fiscal year. The consensus estimate for GMS’ current fiscal year earnings has been revised 25.7% upward over the last 60 days. Motorcar Parts of America is a remanufacturer, manufacturer and distributor of automotive aftermarket parts. This Zacks Rank #1 stock has a Value Score of B. Motorcar Parts of America has an expected year-over-year earnings growth rate of 12.2% for the current fiscal year. The Zacks Consensus Estimate for MPAA's current fiscal year earnings has been revised 1.9% upward over the past 60 days. MDU Resources Group provides value-added natural resource products and related services that are essential for energy transportation, regulated energy delivery, and the construction materials and services business. This Zacks Rank #2 stock has a Value Score of A. MDU Resources Group has an expected year-over-year earnings growth rate of 11.1% for the current year. The Zacks Consensus Estimate for MDU's current-year earnings has been revised 0.9% upward over the past 60 days. VMware is a leading provider of multi-cloud services. This Zacks Rank #2 stock has a Value Score of B. The consensus estimate for VMware's current fiscal year earnings has been revised 3.7% upward over the past 60 days. VMW beat the Zacks Consensus Estimate for earnings in each of the trailing four quarters, the average being 7.2%. 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