Value investors are generally fixated on the price-to-earnings (P/E) multiple while seeking stocks that are trading at a bargain. P/E, without a shadow of doubt, is the most popular multiple used by investors to evaluate the fair market value of a stock. But even this widely-popular valuation metric is not without its pitfalls.
EV/EBITDA is a Better Approach, Here’s Why
While P/E is preferred by many investors while uncovering value stocks, another valuation metric called EV/EBITDA does a better job. The ratio is sometimes viewed as a superior substitute as it offers a clearer picture of a firm’s valuation and its earnings potential. EV/EBITDA has a more comprehensive approach to valuation as it determines a firm’s total value. In contrast, P/E just considers the equity portion of a firm.
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. Essentially, it is the total value of a company.
EBITDA, the other constituent, gives the true picture of a company’s profitability as it removes the impact of non-cash expenses like depreciation and amortization that depress net earnings.
Generally, the lower the EV/EBITDA ratio, the more attractive 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 shortcoming of P/E is that it can’t be used to value a loss-making firm. A company’s earnings are also 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 loss-making but EBITDA-positive.
EV/EBITDA is also a useful yardstick in assessing the value of firms that are highly leveraged and have a high degree of depreciation. It also can be used to compare companies with different levels of debt.
But EV/EBITDA has its downsides too. It varies across industries and is generally not appropriate while comparing stocks in different industries given their diverse capital spending requirements.
Therefore, 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 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.
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 nine stocks that passed the screen:
Hilltop Holdings Inc. HTH offers a wide range of financial products and services in the United States. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 70.3% for the current year. It also has a Value Score of A.
Mr. Cooper Group Inc. COOP provides quality servicing, origination and transaction-based services principally to single-family residences primarily in United States. This Zacks Rank #1 stock has a Value Score of A. Earnings estimates for the company for the current year have moved up 25.5% over the past month. You can see the complete list of today’s Zacks #1 Rank stocks here.
Universal Forest Products, Inc. UFPI is a holding company of businesses that combine to create one of the largest producers of wood and wood-alternative products in North America. This Zacks Rank #1 company has an expected year-over-year earnings growth rate of 21.3% for the current year and a Value Score of B.
Newell Brands Inc. NWL is a global manufacturer and marketer of consumer and commercial products. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 29.5% for the current year and a Value Score of A.
Changyou.com Limited CYOU is a developer and operator of online games in China. This Zacks Rank #2 stock has expected year-over-year earnings growth of 38.9% for the current year and a Value Score of A.
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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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Newell Brands Inc. (NWL) : Free Stock Analysis Report
Changyou.com Limited (CYOU) : Free Stock Analysis Report
Universal Forest Products, Inc. (UFPI) : Free Stock Analysis Report
Hilltop Holdings Inc. (HTH) : Free Stock Analysis Report
MR. COOPER GROUP INC (COOP) : Free Stock Analysis Report
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