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 attractive prices. But even this straightforward, easy-to-calculate equity valuation multiple is not devoid of shortcomings.
What Makes EV/EBITDA a Better Substitute?
While P/E is hands down the most widely used equity valuation ratio in the market, a relatively less used metric called EV/EBITDA is often viewed as a better option as it offers a clearer picture of a company’s valuation and earnings potential. Unlike P/E that solely considers a company’s equity portion, EV/EBITDA determines its total value.
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.
EBITDA 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.
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, 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 key downside of P/E is that it can’t be used to value a loss-making entity. Moreover, a firm’s earnings are subject to accounting estimates and management manipulation. Meanwhile, EV/EBITDA is less open to manipulation and can also be used to value companies that are making loss but are EBITDA-positive.
Moreover, EV/EBITDA is a useful tool in assessing the value of companies that are highly leveraged and have a high degree of depreciation. The ratio also allows the comparison of companies with different debt levels.
Then again, EV/EBITDA has its flaws. It varies across industries (a high-growth industry normally has higher multiple and vice versa) and is typically not appropriate while comparing stocks in different industries given their diverse capital expenditure requirements.
As such, instead of solely banking on EV/EBITDA, 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 true value 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 50,000: 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:
Navios Maritime Partners L.P. NMM is an international owner and operator of dry cargo vessels. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 279.5% for 2020. It also has a Value Score of A.
Qiwi plc QIWI operates as a provider of next generation payment services primarily in Russia and the CIS. This Zacks Rank #1 company has an expected year-over-year earnings growth rate of 33.1% for 2020 and a Value Score of B. You can see the complete list of today’s Zacks #1 Rank stocks here.
DXP Enterprises, Inc. DXPE provides innovative pumping solutions, supply chain services as well as maintenance, repair, operating and production services. This Zacks Rank #2 stock has expected year-over-year earnings growth of 10.5% for 2020 and a Value Score of A.
Legg Mason, Inc. is a global asset management firm focused on the growth and preservation of its clients' capital through its proprietary mutual funds and separately-managed accounts. This Zacks Rank #2 company has an expected year-over-year earnings growth rate of 1,057.9% for the current fiscal year and a Value Score of A.
Schweitzer-Mauduit International, Inc. SWM is a leading global provider of engineered solutions & advanced materials. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 7.1% for 2020 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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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.