Value investors generally have a fixation on the price-to-earnings (P/E) multiple while seeking stocks that are trading at a bargain. P/E, without a shadow of a doubt, is the most popular multiple used by investors to assess the fair market value of a stock. But even this straightforward, broadly used valuation metric suffers a few downsides.
Why EV/EBITDA is a Better Approach?
Although the widespread use of P/E stems from its simplicity, a more-complicated metric called EV/EBITDA is sometimes viewed as a better approach as it offers a clearer picture of a company’s valuation and earnings potential. EV/EBITDA, also referred to as the enterprise multiple, determines the total value of a firm while P/E 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. In a nutshell, it is the total value of a company.
The other element, EBITDA, gives a clearer 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 appealing it is. A low EV/EBITDA ratio could imply that a stock is undervalued.
EV/EBITDA has a more complete approach to valuation. Unlike P/E ratio, it takes debt on a company’s balance sheet into account. Due to this reason, EV/EBITDA is typically used to value possible acquisition targets, as it shows the amount of debt the acquirer has to assume. Stocks with low EV/EBITDA multiple could be seen as attractive takeover candidates.
Another key drawback of P/E is that it can’t be used to value a loss-making entity. A firm’s earnings are also subject to accounting estimates and management manipulation. In contrast, EV/EBITDA is less amenable to manipulation 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.
However, EV/EBITDA is also not without its limitations and alone cannot conclusively determine a stock’s inherent potential and future performance. The ratio varies across industries and is generally not appropriate while comparing stocks in different industries given their diverse capital spending requirements.
Hence, instead of solely relying on EV/EBITDA, you can club it with the other key ratios such as price-to-book (P/B), P/E and price-to-sales (P/S) to achieve the desired outcome.
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 12 stocks that passed the screen:
Popular, Inc. BPOP is a diversified, publicly owned bank holding company. This Zacks Rank #2 stock has expected year-over-year earnings growth of 41.1% for the current year and a Value Score of A.
Fossil Group, Inc. is involved in designing, marketing and distribution of consumer fashion accessories. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 91% 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.
Principal Financial Group, Inc. PFG helps people and companies around the world build, protect and advance their financial well-being through retirement, insurance and asset management solutions that suit their lives. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 6% for the current year and a Value Score of A.
Vipshop Holdings Limited VIPS is an online discount retailer for brands in China. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 39.7% for the current year and a Value Score of A.
Synnex Corporation SNX is a business process services company, which provides business-to-business services that help their customers and business partners grow and enhance their customer-engagement strategies. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 11.1% for the current fiscal year. It has 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.