Investors usually have a fixation with the price-to-earnings (P/E) strategy in their quest for stocks that are trading at a bargain. A widely-favored approach by value investors is to chase stocks that have a low P/E ratio. However, even this straightforward, easy-to-calculate multiple has a few pitfalls.
EV/EBITDA is a Better Approach, But Why? Although P/E is the most commonly used tool for evaluating a firm’s value, another valuation metric called EV/EBITDA works even better. Also known as the enterprise multiple, this ratio is often viewed as a better alternative to P/E as it offers a clearer picture of a company’s valuation and earnings potential. EV/EBITDA also has a more complete approach to valuation as it determines the total value of a firm as opposed to P/E, which only considers 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 entire value of a company. The other component, EBITDA gives the true picture of a firm’s profitability as it eliminates the impact of non-cash expenses like depreciation and amortization that dilute net earnings. 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. 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 bear. Stocks sporting low EV/EBITDA multiple could be seen as attractive 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. In contrast, 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 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. However, EV/EBITDA is not without its limitations. It varies across industries and is usually not appropriate while comparing stocks in different industries given their diverse capital spending requirements. Thus, a strategy only based on EV/EBITDA might not fetch the desired outcome. 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 bargain stocks. Screening Criteria 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. 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. Value Score of less than or equal to B: Here are five of the 17 stocks that passed the screen: Genesco Inc. GCO is a specialty retailer that sells footwear, headwear and accessories in retail stores across the United States and Canada. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 30.5% for the current fiscal year and a Value Score of A. Celestica Inc. CLS is one of the largest electronics manufacturing services company in the world, serving the computer and communications sectors. This Zacks Rank #1 company has an expected year-over-year earnings growth rate of 38.9% for the current year and a Value Score of B. You can see . the complete list of today’s Zacks #1 Rank stocks here Verso Corporation VRS makes printing papers primarily for commercial printing, media and marketing applications. This Zacks Rank #2 stock has a Value Score of A. The company has an expected year-over-year earnings growth rate of 815.8% for the current year. Regal Beloit Corporation RBC is a leading manufacturer of electrical and mechanical motion control products. This Zacks Rank #2 stock has expected year-over-year earnings growth of 5.5% for the current year and a Value Score of A. Qiwi plc ( QIWI Quick Quote QIWI - Free Report) operates as a provider of next generation payment services primarily in Russia and the CIS. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 41% for the current year and a Value Score of A. 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. The Research Wizard is a great place to begin. It's easy to use. Everything is in plain language. And it's very intuitive. Start your Research Wizard trial today. And the next time you read an economic report, open up the Research Wizard, plug your finds in, and see what gems come out. . Click here to sign up for a free trial to the Research Wizard today 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