Investors 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 company. However, even this universally used valuation multiple is not without its limitations.
What Gives EV/EBITDA the Upper Hand?
While P/E is hands down the most popular equity valuation ratio, there is another valuation metric called EV/EBITDA that works even better. This ratio is often viewed as a better alternative to P/E as it offers a clearer picture of a company’s valuation and its earning potential.
Also referred to as the enterprise multiple, 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. In a nutshell, it is the total value of a company.
EBITDA, the other component of the ratio, is a true reflection of a company’s profitability as it strips out non-cash expenses like depreciation and amortization that reduce net earnings. It is also often used as a proxy for cash flows.
Just like P/E, the lower the EV/EBITDA ratio, the better it is. A low EV/EBITDA ratio could signal that a stock is potentially 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 drawback of P/E is that it can’t be used to value a loss-making company. Moreover, a firm’s earnings are subject to accounting estimates and management manipulation. On the other hand, EV/EBITDA is difficult to manipulate and also can be used to value entities that have negative net earnings but are positive on the EBITDA front.
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 a high degree of depreciation.
Then again, EV/EBITDA has its drawbacks 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 expenditure requirements.
As such, a strategy solely based on EV/EBITDA might not yield the desired results. But you can club it with the other major ratios in your stock investing toolbox such as price-to-book (P/B), P/E and price-to-sales (P/S) to screen bargain 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 14 stocks that passed the screen:
Israel Chemicals Ltd. (ICL - Free Report) is a manufacturer of specialty fertilizers and specialty phosphates, flame retardants and water treatment solutions. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 13.5% for the current year. It also has a Value Score of B.
Plains All American Pipeline, L.P. (PAA - Free Report) is engaged in interstate and intrastate marketing, transportation and terminalling of crude oil. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 12.8% for the current year and a Value Score of A. You can see the complete list of today’s Zacks #1 Rank stocks here.
Legg Mason, Inc. (LM - Free Report) , through its subsidiaries, is principally engaged in providing asset management, securities brokerage, investment banking and related financial services to individuals, institutions, corporations and municipalities. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 960.5% for the current fiscal year and a Value Score of A.
NXP Semiconductors N.V. (NXPI - Free Report) is a global semiconductor company that designs and manufactures high performance mixed signal semiconductor solutions to meet the requirements of systems and sub-systems in its target markets. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 5.4% for the current year and a Value Score of B.
OFG Bancorp (OFG - Free Report) is a financial holding company that conducts its business activities through its subsidiaries. The company's products 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 14.5% 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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