Investors typically have a fixation on the price-to-earnings (P/E) multiple, while seeking stocks that are trading at bargain prices. This straight-forward, easy-to-calculate ratio is the most-preferred one among valuation metrics in the investment toolkit for working out the fair market value of a stock. But even this widely used valuation metric is not without its shortcomings.
EV/EBITDA is a Better Alternative, But Why?
While P/E enjoys great popularity, a less-used and more-complicated metric called EV/EBITDA gains an upper hand as it offers a clearer image of a company’s valuation and earnings potential. EV/EBITDA, also known as the enterprise multiple, has a more complete approach to valuation as it determines a firm’s total value. P/E, on the other hand, considers only 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.
The other element of the ratio, EBITDA, 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.
Generally, 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.
Moreover, P/E can’t be used to value a loss-making firm. A company’s earnings are also 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 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.
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 and is generally not appropriate while comparing stocks in different industries given their diverse capital spending requirements.
Therefore, instead of solely banking on EV/EBITDA, you can club 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:
GMS Inc. (GMS - Free Report) is a distributor of wallboard and suspended ceilings systems. This Zacks Rank #1 stock has an expected earnings per share (EPS) growth rate of 7% for three to five years and a Value Score of A.
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 #1 stock has an expected year-over-year earnings growth rate of 139.3% for 2018 and a Value Score of A. You can see the complete list of today’s Zacks #1 Rank stocks here.
Domtar Corporation (UFS - Free Report) is a leading provider of a wide variety of fiber-based products, including communication, specialty and packaging papers, market pulp and absorbent hygiene products. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 39.2% for 2018 and a Value Score of B.
Darling Ingredients Inc. (DAR - Free Report) is a provider of rendering, cooking oil and bakery waste recycling and recovery solutions. The stock has an expected year-over-year earnings growth rate of 370.8% for 2018. It currently has a Value Score of B and a Zacks Rank #1.
MGM Growth Properties LLC (MGP - Free Report) is a real estate investment trust. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 7.5% for 2018 and a Value Score of A.
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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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