Investors generally tend to cling to the price-to-earnings (P/E) metric while looking for bargain stocks. In addition to being a widely used tool for screening stocks, P/E is also a popular metric to work out the fair market value of a firm. But even this ubiquitously used valuation metric suffers a few drawbacks.
Why EV/EBITDA is a Better Substitute to P/E?
The popularity of P/E can be attributed to its apparent simplicity. While it is the most commonly used tool for assessing a firm’s value, a more complicated metric called EV/EBITDA does a better job. Also referred to as enterprise multiple, EV/EBITDA offers a clearer picture of a company’s valuation and its earnings potential. While P/E just considers a firm’s equity portion, EV/EBITDA determines its total value.
EV/EBITDA is essentially the enterprise value (EV) of a stock divided by its earnings before interest, taxes, depreciation and amortization (EBITDA). The first element of the ratio, EV, is a firm’s market capitalization plus the market value of its debt and preferred equity minus cash.
EBITDA, the other constituent of the ratio, is a true reflection 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.
Just like P/E, the lower the EV/EBITDA ratio, the more appealing it is. A low EV/EBITDA ratio could imply that a stock is potentially undervalued and vice versa.
However, unlike P/E ratio, EV/EBITDA takes debt on a company’s balance sheet into account. Due to this reason, EV/EBITDA is generally 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.
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 difficult to manipulate and can also be used to value companies that are making loss but are EBITDA-positive.
EV/EBITDA also allows the comparison of companies with different debt levels and is a useful tool in measuring the value of firms that are highly leveraged and have substantial depreciation and amortization expenses.
But EV/EBITDA is not devoid of limitations and it alone can’t conclusively determine a stock’s inherent potential and its future performance. It varies across industries and is generally not appropriate while comparing stocks in different industries given their diverse capital spending requirements.
As such, instead of solely relying 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 achieve the desired results.
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 10 stocks that passed the screen:
Korea Electric Power Corporation (KEP - Free Report) generates and supplies electric power to its customers, both industrial and residential. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 170.6% for the current year. It also has a Value Score of A.
Popular, Inc. (BPOP - Free Report) is a diversified, publicly owned bank holding company. This Zacks Rank #2 stock has expected year-over-year earnings growth of 26% for the current year and a Value Score of A. You can see the complete list of today’s Zacks #1 Rank stocks here.
Hersha Hospitality Trust (HT - Free Report) is an entrepreneurial, high-growth real estate development and management company focused on the hospitality industry. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 3.6% for the current year. It also has a Value Score of A.
Tech Data Corporation is one of the world's largest technology distributors. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 20.2% for the current fiscal year and a Value Score of A.
OFG Bancorp (OFG - Free Report) is a financial holding company that conducts its business activities through its subsidiaries. The company's product and services consist of consumer banking and lending, commercial banking, and wealth management. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 10.5% for the current year and a Value Score of B.
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Disclosure: Performance information for Zacks’ portfolios and strategies are available at: https://www.zacks.com/performance.