Price-to-earnings (P/E) is among the most preferred valuation metrics in the investment toolkit for working out the fair market value of a stock. The idea of hunting for stocks with a low P/E is ingrained in the minds of many value investors. However, even this simple, easy-to-calculate valuation multiple is not devoid of limitations.
Is EV/EBITDA a Better Option?
While P/E is preferred by many investors while uncovering bargain stocks, another valuation metric called EV/EBITDA does a better job. The ratio is sometimes viewed as a better alternative as it offers a clearer picture of a firm’s valuation and its earnings potential.
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.
EBITDA, the other component, gives the 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.
Typically, the lower the EV/EBITDA ratio, the more enticing it is. A low EV/EBITDA ratio could be a sign that a stock is undervalued.
EV/EBITDA takes a more complete approach to valuation. It takes into account the debt on a company’s balance sheet that P/E ratio ignores. 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.
Another major drawback of P/E is that it can’t be used to value a loss-making firm. A company’s earnings are also subject to accounting estimates and management manipulation. On the other hand, EV/EBITDA is less susceptible to manipulation and can also be used to value companies that have negative net earnings but are positive on the EBITDA front.
EV/EBITDA also allows the comparison of companies with different debt levels and is a useful tool in measuring the value of firms that are highly leveraged and have substantial depreciation and amortization expenses.
Then again, EV/EBITDA has its shortcomings too. It varies across industries (a high-growth industry normally has higher multiple and vice versa) and is generally not appropriate while comparing stocks in different industries given their diverse capital spending requirements.
As such, instead of just relying 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 results.
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 Value Score of A or B when combined with a Zacks Rank #1 or 2 offer the best upside potential.
Here are five of the seven stocks that passed the screen:
Volkswagen Aktiengesellschaft (VLKAY - Free Report) is a leading automobile manufacturer in Europe. This Zacks Rank #1 stock has expected year-over-year earnings growth of roughly 134.4% for 2017. The stock has a Value Score of A.
Fiat Chrysler Automobiles N.V. (FCAU - Free Report) operates as an international automotive company and is engaged in designing, engineering, manufacturing, distributing and selling vehicles and components and production systems. The stock has an expected earnings per share growth rate of 22.4% for three to five years. It has a Value Score of A and a Zacks Rank #1. You can see the complete list of today’s Zacks #1 Rank stocks here.
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. It currently has a Zacks Rank #2 and a Value Score of A. The stock has an expected year-over-year earnings growth rate of 81.8% for 2017.
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 stock has an expected year-over-year earnings growth rate of 13.9% for 2017. It currently has a Value Score of A and a Zacks Rank #2.
M/I Homes, Inc. (MHO - Free Report) is one of the nation's leading builders of single-family homes. The stock has an expected year-over-year earnings growth rate of 37.1% for 2017. It currently has a Value Score of B and a Zacks Rank #2.
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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