Tap 5 Value Stocks With Attractive EV/EBITDA Ratios

Investors generally tend to get fixated on the price-to-earnings (P/E) strategy while seeking bargain stocks. This simple, easy to calculate ratio enjoys greater popularity among valuation metrics in the investment toolkit and is used by many investors for working out the fair market value of a stock. But even this widely popular valuation metric is not without its pitfalls.

EV/EBITDA is a Better Alternative, Here’s Why

Although P/E is the most commonly used valuation metric, a more complicated metric called EV/EBITDA is sometimes viewed as a better option as it offers a clearer picture of a firm’s valuation and its earnings potential.

Also known 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). 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. Essentially, it is the entire value of a company.

EBITDA, the other constituent, gives a true picture of a company’s profitability as it removes 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 attractive it is. A low EV/EBITDA ratio could signal that a stock is potentially undervalued.

EV/EBITDA has a more complete approach to valuation. While P/E just considers a firm’s equity portion, EV/EBITDA determines its total value. Unlike the P/E ratio, EV/EBITDA takes debt on a company’s balance sheet into account. For this reason, EV/EBITDA is commonly used to value potential acquisition targets. The ratio shows the amount of debt the acquirer has to assume. Stocks boasting 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 entity. Moreover, a firm’s earnings are subject to accounting estimates and management manipulation. In contrast, EV/EBITDA is less susceptible to manipulation and can also be used to value firms that have negative net earnings but are positive at the EBITDA level.

Moreover, EV/EBITDA is a useful tool in measuring the value of companies that are highly leveraged and have a high degree of depreciation. The ratio also allows the comparison of companies with different debt levels.

However, EV/EBITDA is not devoid of limitations and it alone can’t conclusively determine a stock’s inherent potential and its future performance. The multiple varies across industries and is usually not appropriate while comparing stocks in different industries given their diverse capital expenditure requirements.

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Thus, instead of solely relying on EV/EBITDA, you can club 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 outcome.

Screening Criteria

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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