Price-to-earnings (P/E) is undoubtedly the most commonly used metric in the value investing world. This simple, easy-to-calculate ratio enjoys greater popularity among valuation metrics in the investment toolkit and is preferred while uncovering stocks that are trading at bargain prices. However, even this equity valuation multiple has a few flaws.

Why EV/EBITDA is a Better Approach?

While P/E is hands down 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 alternative to P/E, this ratio offers a clearer picture of a company’s valuation and its earnings potential. Also known as enterprise multiple, EV/EBITDA determines the total value of a company while P/E just considers its equity portion.

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 firm.

The other component of the ratio, EBITDA, gives the true picture of a firm’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.

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

EV/EBITDA has a more complete approach to valuation. Unlike P/E ratio, it takes debt on a company’s balance sheet into account. Due to this reason, EV/EBITDA is typically used to value possible acquisition targets, as it shows the amount of debt the acquirer has to assume. Stocks with 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. A company’s earnings are also subject to accounting estimates and management manipulation. EV/EBITDA, in contrast, is less amenable to manipulation and can also be used to value companies that are making loss but are EBITDA-positive.

EV/EBITDA is also a useful yardstick in measuring the value of companies with highly leveraged balance sheets as well as significant depreciation and amortization expenses. Moreover, the ratio allows comparison of companies with different debt levels.

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

So, a strategy solely based on EV/EBITDA might not yield the desired results. But 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 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 13 stocks that passed the screen:

Validus Holdings, Ltd. is a global provider of short-tail lines of reinsurance including property catastrophe, property pro-rata and property per risk, marine and energy, and other specialty lines. This Zacks Rank #1 stock has expected EPS growth rate of 9% for 3 to 5 years.

LG Display Co., Ltd. (LPL Quick QuoteLPL - Free Report) primarily makes and markets thin film transistor liquid crystal display (TFT-LCD) panels. This Zacks Rank #1 stock has expected year-over-year earnings growth of 122.4% for 2017.

Lam Research Corporation (LRCX Quick QuoteLRCX - Free Report) designs, manufactures, markets and services semiconductor processing equipment used in the fabrication of integrated circuits. This Zacks Rank #2 stock has an expected EPS growth rate of 11.6% for 3 to 5 years. You can see the complete list of today’s Zacks #1 Rank stocks here.

American Equity Investment Life Holding Company (AEL Quick QuoteAEL - Free Report) is a full service underwriter of a broad line of annuity and insurance products, with primary emphasis on the sale of fixed rate and index annuities. This Zacks Rank #2 stock has an expected year-over-year earnings growth of 69.3% for 2017.

Fossil Group, Inc. (FOSL Quick QuoteFOSL - Free Report) is involved in designing, marketing and distribution of consumer fashion accessories. This Zacks Rank #2 stock delivered an average positive earnings surprise of around 37.8% 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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