Investors typically have a fixation for the price-to-earnings (P/E) strategy while looking for stocks trading at bargain prices. The ratio is widely considered by value investors as a useful tool for working out the fair market value of a stock. However, even this widely popular valuation multiple is not devoid of shortcomings.
What Gives EV/EBITDA the Upper Hand?
Although the widespread popularity of P/E stems from its apparent simplicity, a more complicated metric called EV/EBITDA is often viewed as a better option as it offers a clearer image of a company’s valuation and earnings potential. EV/EBITDA determines the total value of a firm while P/E just considers its equity portion.
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.
The other constituent, EBITDA, gives a better understanding of a company’s profitability as it strips out the impact of non-cash expenses like depreciation and amortization that dilute net earnings.
Generally, the lower the EV/EBITDA ratio, the more tempting it is. A low EV/EBITDA ratio could signal that a stock is potentially undervalued.
EV/EBITDA takes into account the debt on a company’s balance sheet that P/E ratio does not. Given this reason, EV/EBITDA is generally used to value potential acquisition targets as it shows the amount of debt the acquirer has to bear. Stocks with a low EV/EBITDA multiple could be seen as attractive takeover candidates.
Another limitation 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 contrast, EV/EBITDA is hard to manipulate and can also be used to value companies that are making loss but are EBITDA-positive.
EV/EBITDA also allows the comparison of companies with different debt levels and is a useful yardstick in assessing the value of firms that are highly leveraged and have substantial depreciation and amortization expenses.
But EV/EBITDA is not without its downsides. It varies across industries and is usually not appropriate while comparing stocks in different industries given their diverse capital spending requirements.
Thus, instead of solely relying on EV/EBITDA, you can club it with the other key ratios such as price-to-book (P/B), P/E and price-to-sales (P/S) to screen bargain stocks.
Here are the parameters to screen for bargain 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 10 stocks that passed the screen:
Synnex Corporation (SNX - Free Report) is a global IT supply chain services company, offering a comprehensive range of services to original equipment manufacturers, software publishers and reseller customers worldwide. This Zacks Rank #1 stock delivered an average positive earnings surprise of 14.8% in the trailing four quarters.
Plains GP Holdings, L.P. (PAGP - Free Report) , through its subsidiaries, is involved in the transportation, storage, terminalling, and marketing of crude oil and refined products. This Zacks Rank #1 stock has expected year-over-year earnings growth of 105.5% for 2017. You can see the complete list of today’s Zacks #1 Rank stocks here.
LG Display Co., Ltd. (LPL - Free Report) primarily manufactures and sells thin film transistor liquid crystal display (TFT-LCD) panels. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 125.9% for 2017.
Zions Bancorporation (ZION - Free Report) is a multi-bank holding company, focused on maintaining community-minded banking by strengthening its core business lines of retail banking, small and medium-sized business lending, residential mortgage and investment activities. This Zacks Rank #2 stock has an expected earnings per share (EPS) growth rate of 9.3% for three to five years.
Caleres, Inc. (CAL - Free Report) is a footwear retailer and wholesaler, involved in the operation of retail shoe stores and e-commerce Websites as well as the design, sourcing and marketing of footwear for women and men. This Zacks Rank #2 stock has an expected EPS growth rate of 11% for three to five 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.
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.
Zacks Restaurant Recommendations: In addition to dining at these special places, you can feast on their stock shares. A Zacks Special Report spotlights 5 recent IPOs to watch plus 2 stocks that offer immediate promise in a booming sector. Download it free »