The price-to-earnings (P/E) multiple enjoys wide-scale popularity among investors seeking stocks that are trading at attractive prices. In addition to being a widely-used tool for screening stocks, P/E is also a popular metric to work out the fair market value of a firm. However, even this ubiquitously used valuation multiple has a few downsides.
Why EV/EBITDA is a Better Option?
While P/E is undoubtedly the most commonly used equity valuation ratio in the market, a more complicated valuation metric called EV/EBITDA works even better. Often viewed as a better alternative to P/E, EV/EBITDA offers a clearer picture of a company’s valuation and earnings potential.
EV/EBITDA is essentially 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. Basically, it is the full value of a company.
EBITDA, the other component of the multiple, is a true reflection 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.
Typically, 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.
EV/EBITDA, also dubbed as the enterprise multiple, takes a more comprehensive approach to valuation. While P/E just considers a firm’s equity portion, EV/EBITDA determines its total value. EV/EBITDA takes into account the debt on a company’s balance sheet that P/E ratio does not. For this reason, EV/EBITDA is usually used to value possible acquisition targets, as it 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 major downside 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. In comparison, EV/EBITDA is harder to manipulate and can also be used to value firms that have negative net earnings but are positive at the EBITDA level.
EV/EBITDA is also a useful tool in measuring the value of companies with a debt-laden balance sheet and substantial depreciation and amortization expenses. Moreover, the ratio allows the comparison of companies with different debt levels.
But EV/EBITDA is not without its limitations and it alone can’t conclusively determine a stock’s inherent potential and future performance. The multiple varies across industries and is usually not appropriate while comparing stocks in different industries given their diverse capital requirements.
As such, a strategy solely based on EV/EBITDA might not yield the desired results. But you can club it with other key ratios such as price-to-book (P/B), P/E and price-to-sales (P/S) to screen true value stocks.
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 12 stocks that passed the screen:
Teradyne Inc. (TER - Free Report) is a manufacturer of automatic test equipment and related software for the electronics and communications industries. This Zacks Rank #1 stock has an expected EPS growth rate of 12.4% for 3 to 5 years.
Lam Research Corporation (LRCX - Free Report) designs, manufactures, markets and services semiconductor processing equipment used in the fabrication of integrated circuits. This Zacks Rank #1 stock has expected year-over-year earnings growth of 20.5% for 2016.
Regions Financial Corporation (RF - Free Report) is a regional bank holding company and has banking-related subsidiaries engaged in mortgage banking, credit life insurance, leasing, and securities brokerage activities with offices in various Southeastern states. This Zacks Rank #2 company delivered an average positive earnings surprise of around 7.5% over the trailing four quarters. You can see the complete list of today’s Zacks #1 Rank stocks here.
Cosan Limited (CZZ - Free Report) is the leading global ethanol and sugar company in terms of production with low-cost, large-scale and integrated operations in Brazil. This Zacks Rank #2 stock has an expected EPS growth rate of 15.7% for 3 to 5 years.
Preferred Apartment Communities, Inc. (APTS - Free Report) is a real estate investment trust that acquires and operates multifamily properties primarily in the U.S. This Zacks Rank #2 stock has expected year-over-year earnings growth of 12.1% for 2016 and 9.2% for 2017.
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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