The price-to-earnings (P/E) ratio is widely considered by investors as a yardstick for evaluating the fair market value of a stock. Many value investors prefer to take the P/E route in their pursuit for stocks that are trading at a bargain. However, even this universally used valuation multiple is not without its flaws.
What Makes EV/EBITDA a Better Alternative?
Although P/E is preferred by many investors while uncovering bargain 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 considers only a firm’s 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.
The other component of the multiple, EBITDA gives a clearer picture of a company’s profitability as it eliminates the impact of non-cash expenses like depreciation and amortization that dilute net earnings. It is also often used as a proxy for cash flows.
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.
EV/EBITDA takes into account the debt on a company’s balance sheet that P/E ratio does not. Given 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. In contrast, EV/EBITDA is less open 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. Moreover, the ratio allows the comparison of companies with different debt levels.
Then again, EV/EBITDA has its shortcomings too. 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.
Thus, a strategy only based on EV/EBITDA might not fetch the desired results. But you can club it with other key ratios such as price-to-book (P/B), P/E and price-to-sales (P/S) to screen bargain stocks.
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 14 stocks that passed the screen:
Hibbett Sports, Inc. HIBB operates sporting goods stores in small and mid-sized markets. It offers convenient locations and a broad assortment of quality branded athletic footwear, apparel and equipment with a high level of customer service. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 16.9% for the current fiscal year. It also has a Value Score of A.
Genesco Inc. GCO is a specialty retailer that sells footwear, headwear and accessories in retail stores in the United States and Canada. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 11.9% for the current fiscal year and a Value Score of B. You can see the complete list of today’s Zacks #1 Rank stocks here.
Quanta Services, Inc. PWR is a leading specialized contracting services company, delivering infrastructure solutions for the electric power, oil and gas, and communications industries. 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.
Synnex Corporation SNX is a business process services company, which provides business-to-business services that help their customers and business partners grow and enhance their customer-engagement strategies. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 11.1% for the current fiscal year. It has a Value Score of A.
Principal Financial Group, Inc. PFG helps people and companies around the world build, protect and advance their financial well-being through retirement, insurance and asset management solutions that suit their lives. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 3.1% for the current 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.
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Quanta Services, Inc. (PWR) : Free Stock Analysis Report
SYNNEX Corporation (SNX) : Free Stock Analysis Report
Principal Financial Group, Inc. (PFG) : Free Stock Analysis Report
Genesco Inc. (GCO) : Free Stock Analysis Report
Hibbett Sports, Inc. (HIBB) : Free Stock Analysis Report
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