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Pick These 5 Bargain Stocks with Enticing EV/EBITDA Ratios
Value investors generally have a fixation on the price-to-earnings (P/E) multiple 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.
Why EV/EBITDA is a Better Approach?
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.
The other element, EBITDA, 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.
Generally, the lower the EV/EBITDA ratio, the more appealing it is. A low EV/EBITDA ratio could imply that a stock is undervalued.
EV/EBITDA has a more complete approach to valuation. Unlike P/E ratio, it takes debt on a company’s balance sheet into account. Due to this reason, EV/EBITDA is typically used to value possible acquisition targets, as it shows the amount of debt the acquirer has to assume. Stocks with low EV/EBITDA multiple could be seen as attractive takeover candidates.
Another key drawback 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 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.
However, EV/EBITDA is also not without its limitations 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.
Hence, instead of solely 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.
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