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Investors generally have a fixation on the price-to-earnings (P/E) multiple while seeking stocks that are trading at attractive prices. A widely favored approach by value investors is to chase stocks that have a low P/E ratio. But even this widely popular valuation metric is not without its pitfalls.
Why is EV-to-EBITDA a Better Alternative?
While P/E enjoys great popularity among value investors, a less-used and more-complicated metric called EV-to-EBITDA is sometimes viewed as a better alternative. EV-to-EBITDA gives the true picture of a company’s valuation and earning potential. It has a more comprehensive approach to valuation.
EV-to-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, debt and preferred stock minus cash and cash equivalents.
EBITDA, the other component of the multiple, 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.
Usually, the lower the EV-to-EBITDA ratio, the more attractive it is. A low EV-to-EBITDA ratio could signal that a stock is potentially undervalued.
EV-to-EBITDA takes into account the debt on a company’s balance sheet that P/E ratio does not. Given this reason, EV-to-EBITDA is usually used to value possible acquisition targets. Stocks with a low EV-to-EBITDA multiple could be seen as potential takeover candidates.
Moreover, P/E can’t be used to value a loss-making firm. A firm’s earnings are also subject to accounting estimates and management manipulation. On the other hand, EV-to-EBITDA is difficult to manipulate and can also be used to value companies that are making loss but are EBITDA-positive.
EV-to-EBITDA is also a useful tool in assessing the value of firms that are highly leveraged and have a high degree of depreciation. It can also be used to compare companies with different levels of debt.
Then again, EV-to-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, a strategy solely based on EV-to-EBITDA might not yield the desired results. But you can club it with the other major ratios in your stock investing toolbox such as price-to-book (P/B), P/E and price-to-sales (P/S) to screen value stocks.
Here are the parameters to screen for value stocks:
EV-to-EBITDA 12 Months-Most Recent less than X-Industry Median: A lower EV-to-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 14 stocks that passed the screen:
Korea Electric Power Corporation KEP generates and supplies electric power to its customers, both industrial and residential. This Zacks Rank #1 stock has expected year-over-year earnings growth of 38.4% for the current year and a Value Score of A.
Kelly Services, Inc. KELYA is a global leader of providing workforce solutions. This Zacks Rank #2 stock has a Value Score of A. The company beat the Zacks Consensus Estimate for earnings in three of the trailing four quarters at an average of 169.6%. You can see the complete list of today’s Zacks #1 Rank stocks here.
TRI Pointe Group, Inc. TPH is involved in the design, construction and sale of single-family homes. This Zacks Rank #2 stock has a Value Score of A. The company beat the consensus estimate for earnings in each of the trailing four quarters at an average of 51.6%.
ManpowerGroup Inc. MAN is one of the leading providers of innovative workforce solutions and services across the globe. This Zacks Rank #2 stock has a Value Score of A. The Zacks Consensus Estimate for current-year earnings for the company has been revised 2.4% upward over the last 60 days.
Global Net Lease, Inc. GNL is a real estate investment trust. This Zacks Rank #2 stock has a Value Score of B. The consensus estimate for current-year earnings has been revised 6.1% upward over the last 60 days.
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.
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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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ManpowerGroup Inc. (MAN) : Free Stock Analysis Report
Korea Electric Power Corporation (KEP) : Free Stock Analysis Report
Kelly Services, Inc. (KELYA) : Free Stock Analysis Report
TRI Pointe Group, Inc. (TPH) : Free Stock Analysis Report
Global Net Lease, Inc. (GNL) : Free Stock Analysis Report
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