Price-to-earnings (P/E), given its apparent simplicity, is preferred by many investors to handpick stocks trading at attractive prices. A widely favored approach by value investors is to chase 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 Approach, But Why?
While P/E is the most commonly used tool for evaluating a firm’s value, another valuation metric called EV/EBITDA works even better. Also known as the enterprise multiple, this ratio is often viewed as a better alternative to P/E as it offers a clearer picture of a company’s valuation and earnings potential. EV/EBITDA also has a more complete approach to valuation as it determines the total value of a firm as opposed to P/E which only considers its equity portion.
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.
EBITDA, the other element of the ratio, is a true reflection of a company’s profitability as it removes the impact of non-cash expenses like depreciation and amortization that dilute net earnings. It is also often used as a proxy for cash flows.
Just like P/E, the lower the EV/EBITDA ratio, the more appealing it is. A low EV/EBITDA ratio could be a signal that a stock is potentially undervalued.
Unlike P/E ratio, EV/EBITDA takes debt on a company’s balance sheet into account. Due to 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 sporting low EV/EBITDA multiple could be seen as attractive takeover candidates.
Moreover, P/E can’t be used to value a loss-making firm. A firm’s earnings are also subject to accounting estimates and management manipulation. On the other hand, EV/EBITDA is difficult to manipulate and can also be used to value companies that are making loss but are EBITDA-positive.
EV/EBITDA is also a useful yardstick in measuring the value of companies that are highly leveraged and have a high degree of depreciation. Moreover, the ratio allows the comparison of companies with different debt levels.
However, EV/EBITDA is not without its limitations. It varies across industries and is usually not appropriate while comparing stocks in different industries given their diverse capital spending requirements.
As such, a strategy solely based on EV/EBITDA might not fetch the desired outcome. But you can combine 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 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:
Popular, Inc. (BPOP - Free Report) is a diversified, publicly owned bank holding company. This Zacks Rank #1 stock has expected year-over-year earnings growth of roughly 11% for 2017.
National General Holdings Corp. (NGHC - Free Report) is a specialty personal lines insurance holding company that provides personal and commercial automobile insurance, recreational vehicle and motorcycle insurance, supplemental health insurance products and other niche insurance products. This Zacks Rank #2 stock has an expected earnings per share (EPS) growth rate of 15% for three to five years. You can see the complete list of today’s Zacks #1 Rank stocks here.
Regal Beloit Corporation (RBC - Free Report) is a leading manufacturer of electrical and mechanical motion control and power generation products serving markets throughout the world. This Zacks Rank #2 stock has an expected EPS growth rate of 9% for three to five years.
American Equity Investment Life Holding Company (AEL - Free Report) is a full-service underwriter of a broad line of annuity and insurance products, with primary emphasis on the sale of fixed rate and index annuities. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 78.3% for 2017.
UGI Corporation (UGI - Free Report) is a holding company that operates propane distribution, gas and electric utility, energy marketing and related businesses through subsidiaries. This Zacks Rank #2 stock has an expected EPS growth rate of 8% 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 »