Price-to-earnings (P/E), without a shadow of a doubt, is the most popular metric used by investors to handpick stocks that are trading at a discount. A widely favored approach by value investors is to chase for stocks that have a low P/E ratio. However, even this broadly used valuation multiple is not without its shortcomings.
EV/EBITDA is a Better Approach, But Why?
While P/E enjoys huge popularity in the value investing world, a more complicated metric called EV/EBITDA gains an upper hand as it offers a clearer image of a firm’s valuation and earnings potential. EV/EBITDA, also referred to as enterprise multiple, determines the total value of a firm while P/E just 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). EV is the sum of a company’s market capitalization, its debt and preferred stock minus cash and cash equivalents.
EBITDA, the other component of the multiple, 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.
Usually, the lower the EV/EBITDA ratio, the more enticing 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 typically used to value potential acquisition targets as it shows the amount of debt the acquirer has to assume. Stocks with 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 firm. Moreover, a company’s earnings are subject to accounting estimates and management manipulation. In contrast, EV/EBITDA is less open to manipulation and can also be used to value companies that are making loss but are EBITDA-positive.
EV/EBITDA is also a useful yardstick in assessing the value of firms that are highly leveraged and have a high degree of depreciation. It also can be used to compare companies with different levels of debt.
However, EV/EBITDA has its limitations too. It varies across industries and is generally not appropriate while comparing stocks in different industries given their diverse capital spending requirements.
Hence, a strategy entirely based on EV/EBITDA might not fetch the desired results. But you can combine it with other major ratios such as price-to-book (P/B), P/E and price-to-sales (P/S) to screen value 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 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 13 stocks that passed the screen:
Synnex Corporation (SNX - Free Report) is a business process services company, providing a range of distribution, logistics and integration services for the technology industry. This Zacks Rank #1 stock delivered an average positive earnings surprise of 15.1% in the trailing four quarters. The stock has a Value Score of A.
ArcelorMittal (MT - Free Report) is a leading steel company, operating a balanced portfolio of cost competitive steel plants across both the developed and developing markets. The stock has an expected year-over-year earnings growth rate of 128.1% for 2017. It currently 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.
Principal Financial Group, Inc. (PFG - Free Report) is a leading provider of retirement savings, investment and insurance products and services. This Zacks Rank #2 stock has an expected earnings per share (EPS) growth rate of 9.2% for three to five years. The stock has a Value Score of A.
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 14.7% for 2017. It currently has a Value Score of A and a Zacks Rank #2.
Citizens Financial Group, Inc. (CFG - Free Report) is a retail bank holding company, offering 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 21.4% for three to five years. It has a Value Score of B.
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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