Price-to-earnings (P/E) multiple, without a shadow of doubt, enjoys great popularity among investors seeking stocks that are trading at bargain prices. A widely preferred approach by value investors is to chase stocks that flaunt a low P/E ratio. But even this straightforward, ubiquitously used valuation multiple has a few downsides.

What Makes EV/EBITDA a Better Option?

While P/E is the most commonly used metric in the value investing world, 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 alternative to P/E, it offers a clearer picture of a company’s valuation and its earnings potential.

Also known as the enterprise multiple, EV/EBITDA is a more comprehensive one than P/E in stock valuation. EV/EBITDA, in essence, 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. Basically, it is the entire value of a firm.

EBITDA, the other constituent of the ratio, 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.

Just like P/E, the lower the EV/EBITDA ratio, the more attractive it is. A low EV/EBITDA ratio could be a sign that a stock is undervalued and vice versa.

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

Another pitfall of P/E is that it can’t be used to value a loss-making entity. A firm’s earnings are also subject to accounting estimates and management manipulation. On the contrary, 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 also determines the total value of a company while P/E solely considers its equity portion. It is also a useful tool in measuring the value of companies with a debt-laden balance sheet and substantial depreciation and amortization expenses. Moreover, the ratio allows comparison of companies with different debt levels.

But EV/EBITDA is not without its flaws and it alone can’t conclusively determine a stock’s inherent potential and its future performance. The ratio varies across industries (a high-growth industry typically has higher multiple) and is generally not appropriate for comparing stocks in different industries due to their diverse capital expenditure requirements.

So, a strategy solely based on EV/EBITDA might not fetch the desired outcome. But 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 screen true 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.

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.

Value Score of less than or equal to B: Our research shows that stocks with a Style Score of ‘A’ or ‘B’ when combined with a Zacks Rank #1 or 2 offer the best upside potential.

Here are five of the 10 stocks that passed the screen:

Nippon Telegraph and Telephone Corporation offers a range of telecommunications services, including telephone, telegraph, leased circuits, data communication, terminal equipment sales and other services. This Zacks Rank #1 stock has an expected EPS growth rate of 20.6% for 3 to 5 years.

Invesco Mortgage Capital Inc. (IVR Quick QuoteIVR - Free Report) is a real estate investment trust that focuses on financing and managing residential and commercial mortgage-backed securities and mortgage loans. The company carries a Zacks Rank #1 and has an expected EPS growth rate of 5% for 3 to 5 years.

Semiconductor Manufacturing International Corp. (SMI Quick QuoteSMI - Free Report) is one of the leading semiconductor foundries in the world and the largest and most advanced foundry in Mainland China. This Zacks Rank #2 company delivered an average positive earnings surprise of around 53.9% over the trailing four quarters.

Companhia de Saneamento Basico do Estado de Sao Paulo (SBS Quick QuoteSBS - Free Report) provides public water and sewage services to residential, commercial, industrial and governmental customers in Sao Paulo. This Zacks Rank #2 stock has expected year- over-year earnings growth of 231.3% for 2016 and 13.8% for 2017.

OFG Bancorp (OFG Quick QuoteOFG - Free Report) is a financial holding company that conducts its business activities through its subsidiaries, primarily in Puerto Rico. This Zacks Rank #2 stock has expected year-over-year earnings growth of a staggering 379.7% for 2016.

You can get the rest of the stocks on this list by signing up now for your 2-week free trial to the Research Wizard and start using this screen in your own trading. Further, you can also create your own strategies and test them first before taking the investment plunge.

The Research Wizard is a great place to begin. It's easy to use. Everything is in plain language. And it's very intuitive. Start your Research Wizard trial today. And the next time you read an economic report, open up the Research Wizard, plug your finds in, and see what gems come out.

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Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.

Disclosure: Performance information for Zacks’ portfolios and strategies are available at: https://www.zacks.com/performance.

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