Value investors typically tend to get fixated on the price-to-earnings (P/E) strategy while seeking stocks that are trading at a bargain. Undoubtedly, P/E is the most popular multiple used by investors to assess the fair market value of a stock. However, even this widely used valuation metric is not without its pitfalls.
Is EV/EBITDA a Better Alternative to P/E?
While P/E enjoys huge popularity in the value investing world, a more complicated valuation metric called EV/EBITDA works even better. The ratio offers a clearer picture 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. In essence, it is the full value of a firm.
The other component of the ratio, EBITDA is a true reflection of a company’s profitability as it eliminates the impact of non-cash expenses like depreciation and amortization that dilute net earnings.
Just like P/E, the lower the EV/EBITDA ratio, the more appealing it is. A low EV/EBITDA ratio could be a sign that a stock is potentially undervalued.
EV/EBITDA takes into account the debt on a company’s balance sheet that P/E ratio ignores. Given this reason, EV/EBITDA is typically 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 major 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 firms that have negative net earnings but are positive on the EBITDA front.
EV/EBITDA is also a useful yardstick in evaluating 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.
But EV/EBITDA has its downsides too. It varies across industries and is generally not appropriate while comparing stocks in different industries given their diverse capital spending requirements.
Thus, 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 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 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 14 stocks that passed the screen:
Verso Corporation (VRS - Free Report) produces coated freesheet, coated ground wood and uncoated super calendered papers and pulp. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 313.4% for 2018 and a Value Score of A.
Dean Foods Company (DF - Free Report) is a leading food and beverage company in the United States. This Zacks Rank #2 stock has an expected earnings per share (EPS) growth rate of 13.3% for three to five years and a Value Score of A. You can see the complete list of today’s Zacks #1 Rank stocks here.
Tutor Perini Corporation (TPC - Free Report) provides diversified general contracting, construction management and design-build services to private clients and public agencies worldwide. The stock has an expected year-over-year earnings growth rate of 46.1% for 2018. It currently has a Value Score of A and a Zacks Rank #2.
Hilltop Holdings Inc. (HTH - Free Report) is a diversified financial holding company. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 37.7% for 2018 and a Value Score of A.
PennyMac Financial Services, Inc. (PFSI - Free Report) provides financial services primarily in the United States. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 28.8% for 2018 and 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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