Tap 5 Bargain Stocks With Attractive EV/EBITDA Ratios

Price-to-earnings (P/E) is hands down 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.

Why EV/EBITDA is a Better Alternative?

Although 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 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.

EBITDA, the other constituent of the ratio, gives the true picture 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.

Typically, the lower the EV/EBITDA ratio, the more attractive it is. A low EV/EBITDA ratio could signal that a stock is potentially undervalued and vice versa.

However, EV/EBITDA takes into account the debt on a company’s balance sheet that P/E ratio does not. For 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.

Another downside 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. EV/EBITDA, in contrast, is less amenable to manipulation and also can be used to value firms that have negative net earnings but are positive on the EBITDA side.

Moreover, EV/EBITDA determines the total value of a company while P/E only considers its equity portion. 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 limitations. 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.

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Thus, instead of solely relying 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 achieve the desired results.

Screening Criteria

Here are the parameters to screen for true 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 outperformed the market.

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