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Tap 5 Bargain Stocks with Amazingly Low EV/EBITDA Ratios
Price-to-earnings (P/E) is undoubtedly the most commonly used metric in the value investing world. This straightforward, easy to calculate ratio enjoys greater popularity among valuation metrics in the investment toolkit and is preferred while uncovering bargain stocks. A widely favored approach by value investors is to chase stocks with a low P/E ratio. But even this equity valuation multiple is not devoid of shortcomings.
EV/EBITDA is a Better Approach, Here’s Why
While P/E is by far the most popular valuation metric, a more complicated metric called EV/EBITDA does a better job in working out the fair market value of a firm. Often viewed as a better substitute to P/E, this ratio offers a clearer picture of a company’s valuation and its earnings potential.
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 component of the ratio, gives the true 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.
However, 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, as it shows the amount of debt the acquirer has to assume. Companies with a low EV/EBITDA multiple could be seen as attractive takeover candidates.
P/E also can’t be used to value a loss-making firm. A company’s earnings are also subject to accounting estimates and management manipulation. On the other hand, EV/EBITDA is difficult to manipulate 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 is not without its shortcomings. 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, a strategy entirely based on EV/EBITDA might not fetch the desired results. But you can combine it with other major ratios such as price-to-book (P/B), P/E and price-to-sales (P/S) to screen bargain stocks.
For the rest of this Screen of the Week article please visit Zacks.com at:https://www.zacks.com/stock/news/408284/Tap-5-Bargain-Stocks-With-Amazingly-Low-EVEBITDA-Ratios
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