Price-to-earnings (P/E) enjoys greater popularity among the metrics in the value investing world and is preferred by many while uncovering bargain stocks. A widely favored approach by value investors is to hunt for stocks that have a low P/E ratio. However, even this straightforward, easy-to-calculate multiple has a few pitfalls.
EV/EBITDA is a Better Option, But Why?
P/E is by far the most popular metric used by investors due to its simplicity. But a more complicated and less used metric called EV/EBITDA is sometimes viewed as a better alternative as it offers a clearer picture of a firm’s valuation and its earnings potential and has a more complete approach to valuation. While P/E just considers a firm’s equity portion, EV/EBITDA determines its total value.
EV/EBITDA – also known as the enterprise multiple – 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. In essence, it is the entire value of a company.
The other element of the ratio, EBITDA, gives a clearer picture of a company’s profitability as it strips out 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/EBITDA ratio, the more appealing it is. A low EV/EBITDA ratio could imply that a stock is potentially undervalued and vice versa.
Unlike the P/E ratio, EV/EBITDA takes debt on a company’s balance sheet into account. Due to this reason, it is typically used to value potential acquisition targets. The ratio shows the amount of debt that the acquirer has to bear. Stocks flaunting a low EV/EBITDA multiple could be seen as attractive takeover candidates.
Another drawback of P/E is that it can’t be used to value a loss-making company. Moreover, a company’s earnings are subject to accounting estimates and management manipulation. On the contrary, EV/EBITDA is less amenable to manipulation and can also be used to value companies that are making loss but are EBITDA-positive.
EV/EBITDA is also a useful tool in measuring the value of firms that are highly leveraged and have a high degree of depreciation. It also allows the comparison of companies with different debt levels.
However, EV/EBITDA is not without its limitations and it alone can’t conclusively determine a stock’s inherent potential and its future performance. The ratio varies across industries and is usually not appropriate while comparing stocks in different industries given their diverse capital requirements.
So, instead of solely banking on EV/EBITDA, you can combine 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 outcome.
Here are the parameters to screen for true value stocks:
EV/EBITDA 12 Months-Most Recent less than X-Industry Median: A lower EV/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.
Value Score of less than or equal to B: Our research shows that stocks with a Style Score of ‘A’ or ‘B’ when combined with a Zacks Rank #1 or 2 offer the best upside potential.
Here are five of the 11 stocks that passed the screen:
Nippon Telegraph and Telephone Corporation offers a range of telecommunications services, including telephone, telegraph, leased circuits, data communication, terminal equipment sales and other services. This Zacks Rank #1 stock has an expected EPS growth rate of 9.5% for 3 to 5 years.
Amkor Technology, Inc. (AMKR - Free Report) is a leading provider of semiconductor packaging and test services. Moreover, the company is one of the leading developers of advanced semiconductor packaging and test technology. This Zacks Rank #1 stock delivered an average positive earnings surprise of around 131.3% over the trailing four quarters.
Magna International Inc. (MGA - Free Report) is an independent supplier of original equipment components, assemblies, modules and systems and related tooling for cars and light trucks. The company carries a Zacks Rank #2 and has an expected EPS growth rate of 11.7% for 3 to 5 years. You can see the complete list of today’s Zacks #1 Rank stocks here.
Chemtura Corporation is a global producer of specialty chemicals, crop protection and pool, spa and home care products. This Zacks Rank #2 stock has expected year-over-year earnings growth of 22.9% for 2016 and 15.8% for 2017.
Lam Research Corporation (LRCX - Free Report) designs, manufactures, markets and services semiconductor processing equipment used in the fabrication of integrated circuits. This Zacks Rank #2 stock has expected year-over-year earnings growth of 10.8% for 2016.
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.
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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.
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