5 Value Picks With Strikingly Low EV/EBITDA Ratios

Price-to-earnings (P/E), given its apparent simplicity, is preferred by many investors to handpick stocks trading at attractive prices. A widely favored approach by value investors is to chase for stocks that have a low P/E ratio. However, even this straightforward, easy-to-calculate multiple has a few pitfalls.

EV/EBITDA is a Better Approach, But Why?

While P/E is the most commonly used tool for evaluating a firm’s value, another valuation metric called EV/EBITDA works even better. Also known as the enterprise multiple, this ratio is often viewed as a better alternative to P/E as it offers a clearer picture of a company’s valuation and earnings potential. EV/EBITDA also has a more complete approach to valuation as it determines the total value of a firm as opposed to P/E which only 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). The first component of the multiple, EV is the sum of a company’s market capitalization, its debt and preferred stock minus cash and cash equivalents.

EBITDA, the other element of the ratio, 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. It is also often used as a proxy for cash flows.

Just like P/E, the lower the EV/EBITDA ratio, the more appealing it is. A low EV/EBITDA ratio could be a signal that a stock is potentially undervalued.

Unlike P/E ratio, EV/EBITDA takes debt on a company’s balance sheet into account. Due to this reason, EV/EBITDA is generally used to value potential acquisition targets as it shows the amount of debt the acquirer has to bear. Stocks sporting low EV/EBITDA multiple could be seen as attractive takeover candidates.

Moreover, P/E can’t be used to value a loss-making firm. A firm’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 yardstick in measuring the value of companies that are highly leveraged and have a high degree of depreciation. Moreover, the ratio allows the comparison of companies with different debt levels.

However, EV/EBITDA is not without its limitations. It varies across industries and is usually not appropriate while comparing stocks in different industries given their diverse capital spending requirements.

As such, a strategy solely based on EV/EBITDA might not fetch the desired outcome. But you can combine it with the other key ratios such as price-to-book (P/B), P/E and price-to-sales (P/S) to screen bargain stocks.

Screening Criteria

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Here are the parameters to screen for value 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.

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