Price-to-earnings (P/E), without a shadow of a doubt, is the most popular metric used by investors to work out the fair value of a stock. Many prefer to take the P/E route in their quest for stocks that are trading at a discount. However, even this universally used valuation multiple is not without its flaws.

Why EV/EBITDA is a Better Option?

While P/E enjoys great popularity among value investors, a more complicated metric called EV/EBITDA is sometimes viewed as a better alternative. EV/EBITDA gives the true picture of a company’s valuation and its earning potential. Moreover, it has a more complete approach to valuation.  

Also referred to 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 a firm’s market capitalization plus the market value of its debt and preferred equity minus cash.

The other component of the ratio, EBITDA, is a true reflection of a company’s profitability as it eliminates 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 imply that a stock is potentially undervalued and vice versa.

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 consideration. This is also the reason why EV/EBITDA is commonly used to value likely acquisition targets. The ratio shows the amount of debt that the acquirer has to bear. Stocks with a low EV/EBITDA multiple could be seen as attractive takeover candidates.

Another flaw 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. In contrast, EV/EBITDA is less open to manipulation and can also be used to value companies that have negative net earnings but are positive at the EBITDA level.

EV/EBITDA is also a useful tool in measuring the value of firms with a debt-laden balance sheet and have a high degree of depreciation. It also allows the comparison of companies with different debt levels.

Then again, EV/EBITDA has its downsides too. The ratio alone can’t conclusively determine a stock’s inherent potential and its future performance. It varies across industries and is usually not appropriate while comparing stocks in different industries given their diverse capital requirements.

Thus, a strategy solely based on EV/EBITDA might not fetch the desired outcome.  But you can combine it with the other major ratios in your stock investing toolbox such as price-to-book (P/B), P/E and price-to-sales (P/S) to uncover bargain 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:

SYNNEX Corp. (SNX Quick QuoteSNX - Free Report) is a global IT supply chain services company that provides an array of services to resellers and original equipment manufacturers or OEMs. This Zacks Rank #1 stock surpassed estimates in each of the last four quarters at an average rate of 4.7%.

Plains GP Holdings, L.P. (PAGP Quick QuotePAGP - Free Report) , through its subsidiaries, is involved in the transportation, storage, terminalling, and marketing of crude oil and refined products. This Zacks Rank #1 stock has expected year-over-year earnings growth of 56.6% for 2016 and 64.2% for 2017.

Preferred Apartment Communities, Inc. is a real estate investment trust that acquires and operates multifamily properties primarily in the U.S. This Zacks Rank #2 company has an expected EPS growth rate of 7% for 3 to 5 years. You can see the complete list of today’s Zacks #1 Rank stocks here.

POSCO (PKX Quick QuotePKX - Free Report) makes hot and cold rolled steel products, heavy plate and other steel products for the construction and shipbuilding industries. This Zacks Rank #2 stock has a staggering 852.4% expected year-over-year earnings growth for 2016.

The Hanover Insurance Group, Inc. (THG Quick QuoteTHG - Free Report) , through its subsidiaries, offers various property and casualty insurance products and services in the U.S. and internationally. This Zacks Rank #2 stock delivered an average positive earnings surprise of around 8.7% over the trailing four quarters.

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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