5 Value Stocks With Alluring EV/EBITDA Ratios To Own Now

The price-to-earnings (P/E) ratio is widely considered by investors as a yardstick for evaluating the fair market value of a stock. Many value investors prefer to take the P/E route in their pursuit for stocks that are trading at a bargain. But even this straightforward, easy-to-calculate multiple has a few pitfalls.

Is EV/EBITDA a Better Substitute to P/E?

While P/E enjoys great popularity, a less-used metric called EV/EBITDA gains an upper hand as it offers a clearer picture of a company’s valuation and earnings potential. EV/EBITDA, also known as the enterprise multiple, has a more complete approach to valuation as it determines a firm’s total value. P/E, on the other hand, 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 entire value of a company.

The other constituent of the ratio, EBITDA is a true reflection of a company’s profitability as it strips out non-cash expenses like depreciation and amortization that dilute net earnings. It is also often used as a proxy for cash flows.

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.

However, unlike P/E ratio, EV/EBITDA takes into account the debt on a company’s balance sheet. For this reason, EV/EBITDA is usually used to value possible acquisition targets. Stocks with a low EV/EBITDA multiple could be seen as potential takeover candidates.

Another drawback of P/E is that it can’t be used to value a loss-making company. 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. Moreover, the ratio allows the comparison of companies with different debt levels.

Then again, EV/EBITDA has its flaws too. It varies across industries (a high-growth industry normally has higher multiple and vice versa) and is typically not appropriate while comparing stocks in different industries given their diverse capital expenditure requirements.

As such, instead of just banking on EV/EBITDA, you can combine it with the other major ratios such as price-to-book (P/B), P/E and price-to-sales (P/S) to screen true value stocks.

Screening Criteria

Here are the parameters to screen for value stocks:

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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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