Investors typically tend to cling to the price-to-earnings (P/E) strategy while seeking stocks that are trading at bargain prices. Undoubtedly, P/E is the most popular multiple used by investors for assessing the fair market value of a stock. However, even this straightforward, easy-to-calculate metric has a few downsides.
What Makes EV/EBITDA a Better Alternative?
While P/E is the most commonly used equity valuation ratio in the market, a more complicated valuation metric called EV/EBITDA is often viewed as a better alternative as it offers a clearer picture of a firm’s valuation and its earnings potential. EV/EBITDA determines the total value of a company while P/E just considers its equity portion.
Also called 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. In a nutshell, it is the entire value of a company.
EBITDA, the other element of the ratio, gives the true picture of a firm’s profitability as it eliminates the impact of non-cash expenses like depreciation and amortization that reduce net earnings. It is also often used as a proxy for cash flows.
Typically, the lower the EV/EBITDA ratio, the more appealing it is. A low EV/EBITDA ratio could imply that a stock is undervalued.
However, unlike P/E ratio, EV/EBITDA takes debt on a company’s balance sheet into account. For this reason, EV/EBITDA is usually 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 limitation 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. EV/EBITDA, in contrast, is hard to manipulate and can also be used to value companies that have negative net earnings but are positive on the EBITDA front.
EV/EBITDA is also a useful yardstick in assessing the value of companies with a debt-laden balance sheet as well as significant depreciation and amortization expenses. The ratio also allows the comparison of firms with different debt levels.
Then again, EV/EBITDA has its flaws too. It alone cannot conclusively determine a stock’s inherent potential and its future performance. The ratio varies across industries and is generally not appropriate while comparing stocks in different industries given their diverse capital expenditure requirements.
Thus, instead of solely banking on EV/EBITDA, you can club it with the other major ratios such as price-to-book (P/B), P/E and price-to-sales (P/S) to achieve the desired results.
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 Style 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:
ArcBest Corporation ARCB provides freight transportation services and solutions globally. This Zacks Rank #1 stock has expected year-over-year earnings growth of 79.4% for 2017.
Prudential Financial, Inc. PRU is one of the largest financial services institutions in the U.S. It offers a wide range of insurance, investment management and other financial products and services. This Zacks Rank #2 stock has an expected EPS growth rate of 8.5% for 3 to 5 years.
Summit Hotel Properties, Inc. INN is a publicly traded real estate investment trust focused mainly on owning premium-branded, select-service hotels in the upscale and upper midscale segments of the lodging industry. This Zacks Rank #2 stock delivered an average positive earnings surprise of around 11.7% over the trailing four quarters. You can see the complete list of today’s Zacks #1 Rank stocks here.
TTM Technologies, Inc. TTMI provides time-critical, one-stop manufacturing services for the highly complex printed circuit boards. This Zacks Rank #2 company delivered an average positive earnings surprise of around 29% over the trailing four quarters.
Popular, Inc. BPOP is a diversified, publicly owned bank holding company. This Zacks Rank #2 stock has expected year-over-year earnings growth of 17.6% for 2017.
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.
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