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Investors tend to get fixated on the price-to-earnings (P/E) strategy while seeking stocks that are trading at a bargain. P/E, without a shadow of a doubt, is the most popular multiple used by investors to assess the fair market value of a stock. But even this straightforward, broadly used valuation metric suffers a few downsides.
EV/EBITDA is a Better Approach, Here’s 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. EV/EBITDA, also referred to as the enterprise multiple, determines the total value of a firm while P/E considers only 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 total value of a company.
EBITDA, the other constituent, gives a clearer picture of a company’s profitability as it eliminates 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.
Generally, the lower the EV/EBITDA ratio, the more enticing it is. A low EV/EBITDA ratio could signal that a stock is potentially undervalued.
EV/EBITDA takes into account the debt on a company’s balance sheet that P/E ratio does not. 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 assume. Stocks boasting a low EV/EBITDA multiple could be seen as attractive takeover candidates.
Another key drawback of P/E is that it cannot be used to value a loss-making entity. A firm’s earnings are also subject to accounting estimates and management manipulation. In contrast, EV/EBITDA is less amenable to manipulation and can also be used to value companies that are making loss but are EBITDA-positive.
EV/EBITDA is also a useful tool in measuring the value of firms that are highly leveraged and have a high degree of depreciation. It also allows the comparison of companies with different debt levels.
But EV/EBITDA has its limitations too. The ratio varies across industries (a high-growth industry typically has higher multiple and vice versa) and is usually not appropriate while comparing stocks in different industries given their diverse capital requirements.
Hence, instead of just relying on EV/EBITDA, you can club it with the other key ratios such as price-to-book (P/B), P/E and price-to-sales (P/S) to achieve the desired outcome.
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 13 stocks that passed the screen:
Donnelley Financial Solutions, Inc. DFIN is a leader in risk and compliance solutions, offering insightful technology, industry expertise and data insights to clients globally. This Zacks Rank #1 stock has expected year-over-year earnings growth of 15.4% for the current 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 #2 company has an expected year-over-year earnings growth rate of 14.8% for the current year and a Value Score of A. You can see the complete list of today’s Zacks #1 Rank stocks here.
United States Cellular Corporation USM offers wireless telecommunications services in the United States. This Zacks Rank #2 stock has expected year-over-year earnings growth of 6.3% for the current year and a Value Score of A.
Diamond S Shipping Inc. DSSI provides seaborne transportation of crude oil, refined petroleum and other products in international shipping markets. This Zacks Rank #2 stock has expected year-over-year earnings growth of 1,191.7% for the current year and a Value Score of A.
Heritage Insurance Holdings, Inc. HRTG is a property and casualty insurance holding company. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 69.5% for the current fiscal 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.
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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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United States Cellular Corporation (USM) : Free Stock Analysis Report
Celestica, Inc. (CLS) : Free Stock Analysis Report
Heritage Insurance Holdings, Inc. (HRTG) : Free Stock Analysis Report
Donnelley Financial Solutions Inc. (DFIN) : Free Stock Analysis Report
Diamond S Shipping Inc. (DSSI) : Free Stock Analysis Report
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