5 Stocks With Alluring EV/EBITDA Ratios To Scoop Up Now

Price-to-earnings (P/E), without a shadow of a doubt, is the most popular metric used by investors to handpick stocks that are trading at a discount. A widely favored approach by value investors is to chase for stocks that have a low P/E ratio. However, even this broadly used valuation multiple is not without its shortcomings.

EV/EBITDA is a Better Approach, But Why?

While P/E enjoys huge popularity in the value investing world, a more complicated metric called EV/EBITDA gains an upper hand as it offers a clearer image of a firm’s valuation and earnings potential. EV/EBITDA, also referred to as enterprise multiple, determines the total value of a firm while P/E just considers 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.

EBITDA, the other component of the multiple, is a true reflection of a company’s profitability as it removes the impact of non-cash expenses like depreciation and amortization that dilute net earnings.

Usually, 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. Given this reason, EV/EBITDA is typically 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 downside of P/E is that it can’t be used to value a loss-making firm. Moreover, a company’s earnings are 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 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.

However, EV/EBITDA has its limitations too. It varies across industries and is generally not appropriate while comparing stocks in different industries given their diverse capital spending 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 value stocks.

Screening Criteria

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.

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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.

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