Investors generally tend to get fixated on the price-to-earnings (P/E) strategy while seeking bargain stocks. This simple, easy to calculate ratio enjoys greater popularity among valuation metrics in the investment toolkit and is used by many investors for working out the fair market value of a stock. But even this widely popular valuation metric is not without its pitfalls.
EV/EBITDA is a Better Alternative, Here’s Why
Although P/E is the most commonly used valuation metric, a more complicated metric called EV/EBITDA is sometimes viewed as a better option as it offers a clearer picture of a firm’s valuation and its earnings potential.
Also known as the enterprise multiple, EV/EBITDA is the enterprise value (EV) of a stock divided by its earnings before interest, taxes, depreciation and amortization (EBITDA). The first component of the multiple, EV is the sum of a company’s market capitalization, its debt and preferred stock minus cash and cash equivalents. Essentially, it is the entire value of a company.
EBITDA, the other constituent, gives a true picture of a company’s profitability as it removes the impact of non-cash expenses like depreciation and amortization that depress net earnings. It is also often used as a proxy for cash flows.
Generally, the lower the EV/EBITDA ratio, the more attractive it is. A low EV/EBITDA ratio could signal that a stock is potentially undervalued.
EV/EBITDA has a more complete approach to valuation. While P/E just considers a firm’s equity portion, EV/EBITDA determines its total value. Unlike the P/E ratio, EV/EBITDA takes debt on a company’s balance sheet into account. For this reason, EV/EBITDA is commonly used to value potential acquisition targets. The ratio shows the amount of debt the acquirer has to assume. Stocks boasting a low EV/EBITDA multiple could be seen as attractive takeover candidates.
Another downside of P/E is that it can’t be used to value a loss-making entity. Moreover, a firm’s earnings are subject to accounting estimates and management manipulation. In contrast, EV/EBITDA is less susceptible to manipulation and can also be used to value firms that have negative net earnings but are positive at the EBITDA level.
Moreover, EV/EBITDA is a useful tool in measuring the value of companies that are highly leveraged and have a high degree of depreciation. The ratio also allows the comparison of companies with different debt levels.
However, EV/EBITDA is not devoid of limitations and it alone can’t conclusively determine a stock’s inherent potential and its future performance. The multiple varies across industries and is usually not appropriate while comparing stocks in different industries given their diverse capital expenditure requirements.
Thus, instead of solely relying on EV/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 outcome.
Here are the parameters to screen for 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 18 stocks that passed the screen:
Greif, Inc. (GEF - Free Report) is engaged in providing industrial packaging products and services. It makes steel, plastic, fibre, flexible and corrugated containers, packaging accessories and containerboard, and provides blending, filling and packaging services. This Zacks Rank #1 stock has an expected EPS growth rate of 8.7% for 3 to 5 years.
TTM Technologies Inc. (TTMI - Free Report) offers time-critical, one-stop manufacturing services for highly complex printed circuit boards. Its printed circuit boards serve as the foundation of electronic products such as routers, switches, computer memory modules and communications infrastructure equipment. This Zacks Rank #1 stock has a staggering 528.6% expected year-over-year earnings growth for 2016.
Celestica Inc. (CLS - Free Report) is one of the largest electronics manufacturing services company in the world, serving the computer, and communications sectors. This Zacks Rank #2 stock has expected year-over-year earnings growth of 66.2% for 2016. You can see the complete list of today’s Zacks #1 Rank stocks here.
Comfort Systems USA Inc. (FIX - Free Report) is a national provider of comprehensive heating, ventilation and air conditioning installation, maintenance, repair and replacement services. This Zacks Rank #2 company delivered an average positive earnings surprise of around 15.8% over the trailing four quarters.
Citizens Financial Group, Inc. (CFG - Free Report) is a retail bank holding company. It offers a broad range of retail and commercial banking products and services to individuals, small businesses, middle-market companies, large corporations and institutions. This Zacks Rank #2 stock has an expected EPS growth rate of 18% for 3 to 5 years.
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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