Value investors generally tend to cling to the price-to-earnings (P/E) strategy while seeking stocks that are trading at bargain 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 straightforward, broadly used valuation metric suffers a few downsides.
Why EV/EBITDA is a Better Alternative?
While P/E is hands down the most commonly used equity valuation ratio in the market, a relatively less-used metric called EV/EBITDA is often viewed as a better option as it offers a clearer image of a company's valuation and earnings potential. Unlike P/E that solely considers a company's equity portion, EV/EBITDA determines its total value.
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 essence, it is the full value of a company.
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.
Typically, the lower the EV/EBITDA ratio, the more enticing it is. A low EV/EBITDA ratio could imply that a stock is potentially undervalued and vice versa.
EV/EBITDA also takes into account the debt on a company's balance sheet that P/E does not. Given 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 with a low EV/EBITDA multiple could be seen as attractive takeover candidates.
Another major 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. In contrast, EV/EBITDA is hard to manipulate and can also be used to value firms that have negative net earnings but are positive on the EBITDA front.
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 is also not without its shortcomings and alone cannot conclusively determine a stock's inherent potential and future performance. The ratio varies across industries and is generally not appropriate while comparing stocks in different industries given their diverse capital spending 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 true value 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 13 stocks that passed the screen:
Kraton CorporationKRA is a producer of styrenic block copolymers, specialty polymers and performance products derived from pine wood pulping co-products. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 25.4% for 2017. It has a Value Score of A.
Cosan LimitedCZZ is the leading global ethanol and sugar company in terms of production with low-cost, large-scale and integrated operations in Brazil. The stock has an expected year-over-year earnings growth rate of 197% for 2017. It currently has a Value Score of A and a Zacks Rank #1. You can see the complete list of today's Zacks #1 Rank stocks here .
Synnex CorporationSNX is a global information technology supply chain services company offering a comprehensive range of services to original equipment manufacturers, software publishers and reseller customers worldwide. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 24.9% for 2017. It has a Value Score of B.
Plains GP Holdings, L.P.PAGP , through its subsidiaries, is involved in the transportation, storage, terminalling, and marketing of crude oil and refined products. The stock has an expected year-over-year earnings growth rate of 41.2% for 2017. It currently has a Value Score of A and a Zacks Rank #2.
Fiat Chrysler Automobiles N.V.FCAU operates as an international automotive company. This Zacks Rank #2 stock has an expected earnings per share (EPS) growth rate of 19% for three to five years. It has 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.
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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