Value investors generally tend to cling to the price-to-earnings (P/E) strategy while looking for stocks that are trading at a bargain. Undoubtedly, P/E is the most popular multiple used by investors for assessing the fair market value of a stock. However, even this straightforward, broadly used valuation metric suffers a few downsides.
EV/EBITDA is a Better Option, Here’s Why?
Although P/E is the most commonly used tool for evaluating a firm’s value, another valuation metric called EV/EBITDA works even better. The ratio is often viewed as a better alternative to P/E as it offers a clearer image of a company’s valuation and its earnings potential. EV/EBITDA also has a more complete approach to valuation. Unlike P/E, which solely considers a company’s equity portion, EV/EBITDA determines its total value.
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. Simply put, it is the total value of a firm.
The other element, EBITDA gives the true picture of a firm’s profitability as it eliminates the impact of non-cash expenses like depreciation and amortization that dilute net earnings.
Usually, the lower the EV/EBITDA ratio, the more attractive it is. A low EV/EBITDA ratio could imply that a stock is potentially undervalued and vice versa.
EV/EBITDA also takes into account the debt on a company’s balance sheet that P/E ratio ignores. For this reason, EV/EBITDA is usually used to value possible acquisition targets. Stocks with a low EV/EBITDA multiple could be seen as potential takeover candidates.
Another major shortcoming of P/E is that it can’t be used to value a loss-making entity. Moreover, a firm’s earnings are subject to accounting estimates and management manipulation. In contrast, EV/EBITDA EV/EBITDA is less open to manipulation and can also be used to value companies that are making loss but are EBITDA-positive.
Moreover, EV/EBITDA is a useful tool in assessing the value of companies that are highly leveraged and have a high degree of depreciation. The ratio also allows the comparison of companies with different debt levels.
However, EV/EBITDA is not without its flaws and it alone can’t conclusively determine a stock’s inherent potential and future performance. It varies across industries (a high-growth industry normally has higher multiple and vice versa) and is typically not appropriate while comparing stocks in different industries given their diverse capital expenditure requirements.
Thus, instead of solely banking 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 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 11 stocks that passed the screen:
PennyMac Mortgage Investment Trust (PMT - Free Report) is a real estate investment trust. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 27.7% for 2018 and a Value Score of A.
Atlas Air Worldwide Holdings, Inc. (AAWW - Free Report) is a leading provider of outsourced aircraft and aviation operating services. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 26.2% for 2018 and a Value Score of B. You can see the complete list of today’s Zacks #1 Rank stocks here.
Boise Cascade Company (BCC - Free Report) operates as a wood products manufacturer and building materials distributor. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 74.9% for 2018 and a Value Score of B.
UGI Corporation (UGI - Free Report) distributes, stores, transports and markets energy products and related services. The stock has an expected year-over-year earnings growth rate of 17.9% for fiscal 2018. It currently has a Value Score of A and a Zacks Rank #2.
Covenant Transportation Group, Inc. (CVTI - Free Report) is a truckload carrier that offers just-in-time and other premium transportation services throughout the United States. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 125% for 2018 and a Value Score of A.
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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