Value investors generally tend to cling to the price-to-earnings (P/E) strategy while seeking stocks that are trading at attractive prices. P/E, without a shadow of a doubt, is the most popular multiple used by investors for evaluating the fair market value of a stock. But even this ubiquitously used equity valuation multiple is not devoid of shortcomings.
EV/EBITDA is a Better Option, But Why?
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. Also known as the enterprise multiple, EV/EBITDA determines the total value of a firm while P/E just 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. Simply put, it is the total value of a firm.
EBITDA, the other element of the ratio, 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.
Just like P/E, the lower the EV/EBITDA ratio, the more alluring it is. A low EV/EBITDA ratio could be a sign 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 with a 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. 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 is also a useful tool in evaluating the value of firms that are highly leveraged and have a high degree of depreciation. Moreover, it can be used to compare companies with different levels of debt.
But EV/EBITDA has its downsides too. It alone can’t conclusively determine a stock’s inherent potential and future performance. The ratio varies across industries and is usually not appropriate while comparing stocks in different industries given their diverse capital spending requirements.
Thus, instead of just relying 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 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 13 stocks that passed the screen:
Covenant Transportation Group, Inc. CVTI is a truckload carrier that offers just-in-time and other premium transportation service for customers throughout the United States. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 100% for 2018 and a Value Score of A.
Kulicke and Soffa Industries, Inc. KLIC is a leading provider of semiconductor packaging and electronic assembly solutions, supporting the global automotive, consumer, communications, computing and industrial segments. This Zacks Rank #1 stock has an expected earnings per share (EPS) growth rate of 12% for three to five years and a Value Score of B. You can see the complete list of today’s Zacks #1 Rank stocks here.
TrueBlue, Inc. TBI is a leading provider of specialized workforce solutions. The stock has an expected year-over-year earnings growth rate of 27% for 2018. It currently has a Value Score of A and a Zacks Rank #2.
Haverty Furniture Companies, Inc. HVT is a full-service home furnishings retailer. This Zacks Rank #2 stock has delivered an average positive earnings surprise of around 28.7% over the trailing four quarters. It also has a Value Score of A.
Graphic Packaging Holding Company GPK is a leading provider of paperboard packaging solutions for a wide variety of products to food, beverage and other consumer products companies. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 54% for 2018 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.
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.
Zacks Restaurant Recommendations: In addition to dining at these special places, you can feast on their stock shares. A Zacks Special Report spotlights 5 recent IPOs to watch plus 2 stocks that offer immediate promise in a booming sector. Download it free »
Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free report
Covenant Transportation Group, Inc. (CVTI) : Free Stock Analysis Report
Kulicke and Soffa Industries, Inc. (KLIC) : Free Stock Analysis Report
Graphic Packaging Holding Company (GPK) : Free Stock Analysis Report
Haverty Furniture Companies, Inc. (HVT) : Free Stock Analysis Report
TrueBlue, Inc. (TBI) : Free Stock Analysis Report
To read this article on Zacks.com click here.
Zacks Investment Research