The price-to-earnings (P/E) ratio is by far the most widely used metric in the value investing world due to its simplicity. Many prefer to take the P/E route in their pursuit of stocks that are trading at bargain prices. The idea of chasing stocks with a low P/E is ingrained in the minds of many value investors. However, even this straightforward, ubiquitously used valuation multiple is not without its shortcomings.

Is EV/EBITDA a Better Approach?

Although P/E is the most popular yardstick for evaluating a firm’s value, a more complicated valuation multiple called EV/EBITDA works even better. Often viewed as a better alternative to P/E, this ratio offers a clearer picture of a firm’s valuation and its earnings potential. EV/EBITDA determines the total value of a company while P/E solely considers its equity portion.

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). EV is the sum of a company’s market capitalization, its debt and preferred stock minus cash and cash equivalents. In essence, it is the entire value of a company.

The other component of the ratio, EBITDA, is a true reflection of a firm’s profitability as it removes the impact of non-cash expenses like depreciation and amortization that reduce net earnings. It is also often used as a proxy for cash flows.

Generally, the lower the EV/EBITDA ratio, the more enticing it is. A low EV/EBITDA ratio could be a sign that a stock is undervalued.

Unlike P/E ratio, EV/EBITDA takes into account the debt on a company’s balance sheet. This is why EV/EBITDA is typically used to value possible acquisition targets, as it shows the amount of debt the acquirer has to assume. Stocks flaunting a low EV/EBITDA multiple could be seen as attractive takeover candidates.

Moreover, P/E 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 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 assessing the value of companies with a debt-laden balance sheet and considerable depreciation and amortization expenses. Moreover, the ratio allows the comparison of companies with different debt levels.

However, 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 (a high-growth industry generally has higher multiple) and is generally not appropriate while comparing stocks in different industries given their diverse capital requirements.

As such, a strategy solely based on EV/EBITDA might not fetch the desired outcome. But you can combine it with other major ratios such as price-to-book (P/B), P/E and price-to-sales (P/S) to screen value stocks.

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.

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 14 stocks that passed the screen:

Teradyne Inc. (TER Quick QuoteTER - Free Report) is a manufacturer of automatic test equipment and related software for the electronics and communications industries. This Zacks Rank #1 company delivered an average positive earnings surprise of around 19.3% over the trailing four quarters.

Fiat Chrysler Automobiles N.V. operates as an international automotive company. This Zacks Rank #2 stock has an expected EPS growth rate of 28.9% for 3 to 5 years.

KB Home (KBH Quick QuoteKBH - Free Report) constructs and markets a range of new homes designed primarily for first-time, move-up and active adult homebuyers, including attached and detached single-family residential homes, townhomes and condominiums. This Zacks Rank #2 stock has an expected EPS growth rate of 27.9% for 3 to 5 years. You can see the complete list of today’s Zacks #1 Rank stocks here.

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 stock delivered an average positive earnings surprise of around 41.4% over the trailing four quarters.

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 stock has expected year-over-year earnings growth of 12.1% for 2016 and 9.2% for 2017.

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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