Price-to-earnings (P/E), due to its apparent simplicity, is preferred by many investors while picking 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 simple, easy-to-calculate multiple has a few pitfalls.
Why EV/EBITDA is a Better Approach?
Although 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. Simply put, it is the total value of a firm.
EBITDA, the other constituent, 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.
However, unlike P/E ratio, EV/EBITDA takes into account the debt on a company’s balance sheet. 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 drawback of P/E is that it can’t be used to value a loss-making firm. Moreover, a company’s earnings are also subject to accounting estimates and management manipulation. On the other hand, EV/EBITDA is harder to manipulate and can also be used to value companies that have negative net earnings but are positive on the EBITDA front.
EV/EBITDA is also a useful yardstick in measuring the value of companies that are highly leveraged and have a high degree of depreciation. It also allows comparison of companies with different debt levels.
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, a strategy only based on EV/EBITDA might not yield the desired outcome. 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 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:
Big 5 Sporting Goods Corporation (BGFV - Free Report) is a sporting goods retailer in the United States. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 19.3% for 2018 and a Value Score of A.
ArcBest Corporation (ARCB - Free Report) provides freight transportation services and solutions. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 120.3% for 2018 and a Value Score of A. 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.
Rayonier Advanced Materials Inc. (RYAM - Free Report) operates as a global supplier of cellulose specialties products, a natural polymer for the chemical industry. This Zacks Rank #2 stock has a Value Score of A and an expected year-over-year earnings growth rate of 97.9% for 2018.
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 19.2% for fiscal 2018. It currently has a Value Score of A 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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