Price-to-earnings (P/E), given its apparent simplicity, is the most commonly used metric in the value investing world. The ratio enjoys greater popularity among valuation metrics in the investment toolkit and is preferred while uncovering stocks trading at a bargain. But even this straightforward, easy-to-calculate equity valuation multiple is not devoid of limitations.
EV/EBITDA is a Better Approach, Here’s Why
While P/E is by far the most-popular valuation metric, a more-complicated metric called EV/EBITDA does a better job in working out the fair market value of a firm. Often viewed as a better substitute to P/E, this ratio offers a clearer picture of a company’s valuation and its earnings potential.
Also dubbed as the enterprise multiple, EV/EBITDA is essentially 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. Essentially, it is the total value of a company.
EBITDA, the other component of the ratio, gives the true picture of a company’s profitability as it eliminates 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 enticing it is. A low EV/EBITDA ratio could signal that a stock is potentially undervalued.
However, EV/EBITDA takes into account the debt on a company’s balance sheet that P/E ratio does not. Given this reason, EV/EBITDA is usually used to value possible acquisition targets, as it shows the amount of debt the acquirer has to assume. Companies with a low EV/EBITDA multiple could be seen as attractive takeover candidates.
P/E also can’t be used to value a loss-making firm. A company’s earnings are also subject to accounting estimates and management manipulation. On the other hand, EV/EBITDA is difficult to manipulate and can also be used to value companies that are making loss but are EBITDA-positive.
EV/EBITDA is also a useful tool in measuring the value of firms that are highly leveraged and have a high degree of depreciation. It also allows the comparison of companies with different debt levels.
But EV/EBITDA is not without its shortcomings. The ratio varies across industries (a high-growth industry typically has higher multiple and vice versa) and is usually not appropriate while comparing stocks in different industries given their diverse capital requirements.
Hence, a strategy entirely based on EV/EBITDA might not fetch the desired results. 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 15 stocks that passed the screen:
Quanta Services, Inc. (PWR - Free Report) is a leading specialized contracting services company, delivering infrastructure solutions for the electric power, oil and gas and communications industries. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 25.3% for the current year and a Value Score of B.
BBX Capital Corporation (BBX - Free Report) is involved in the acquisition, ownership and management of joint ventures and investments in real estate and real estate development projects and middle market operating businesses. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 28.6% for the current year. It also has a Value Score of A. You can see the complete list of today’s Zacks #1 Rank stocks here.
Textron Inc. (TXT - Free Report) is one of the world’s best-known multi-industry companies that leverages its global network of aircraft, defense, industrial and finance businesses to provide customers with innovative products and services. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 9.9% for the current year and a Value Score of A.
Expedia Group, Inc. (EXPE - Free Report) is an online travel company, empowering business and leisure travelers through technology with the tools and information they need to efficiently research, plan, book and experience travel. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 22.2% for the current year. It also has a Value Score of B.
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 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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