Value investors tend to cling to the price-to-earnings (P/E) strategy while looking for stocks that are trading at attractive prices. P/E, without a shadow of a doubt, is the most popular multiple used by investors for evaluating the fair market value of a stock. But even this straightforward, ubiquitously used valuation metric is not without its downsides.

Is EV/EBITDA a Better Substitute to P/E?

While P/E, given its simplicity, is hands down the most commonly used equity valuation ratio in the market, a more complicated metric called EV/EBITDA is often viewed as a better option as it offers a clearer image of a company’s valuation and earnings potential. Unlike P/E that solely considers a company’s equity portion, EV/EBITDA determines its total value.

EV/EBITDA, also dubbed as the enterprise multiple, 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 full value of a company.

EBITDA, the other component of the multiple, is a true reflection of a company’s profitability as it removes the impact of non-cash expenses like depreciation and amortization that dilute net earnings.

Generally, the lower the EV/EBITDA ratio, the more attractive it is. A low EV/EBITDA ratio could imply that a stock is potentially undervalued and vice versa.

EV/EBITDA also takes into account the debt on a company’s balance sheet that P/E does not. For this reason, EV/EBITDA is usually used to value possible acquisition targets, as it 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 limitation 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. EV/EBITDA, in contrast, is hard to manipulate and can also be used to value firms that have negative net earnings but are positive on the EBITDA front.

EV/EBITDA is also a useful yardstick in measuring the value of firms that are highly leveraged and have a high degree of depreciation. It also can be used to compare companies with different levels of debt.

But EV/EBITDA is not without its limitations and it alone can’t conclusively determine a stock’s inherent potential and future performance. The ratio varies across industries and is generally not appropriate while comparing stocks in different industries given their diverse capital spending requirements.

Thus, a strategy solely based on EV/EBITDA might not fetch the desired results. But you can club it with other key 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 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 15 stocks that passed the screen:

ArcelorMittal (MT Quick QuoteMT - Free Report) is a leading steel company, operating a balanced portfolio of cost competitive steel plants across both the developed and developing markets. This Zacks Rank #1 stock has an expected earnings per share (EPS) growth rate of 11.6% for 3 to 5 years.

LG Display Co., Ltd. (LPL Quick QuoteLPL - Free Report) primarily manufactures and sells thin film transistor liquid crystal display (TFT-LCD) panels. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 84.5% for 2017. You can see the complete list of today’s Zacks #1 Rank stocks here.

Boise Cascade Company (BCC Quick QuoteBCC - Free Report) operates as a wood products manufacturer and building materials distributor. This Zacks Rank #1 stock delivered an average positive earnings surprise of 114.7% in the trailing four quarters.

Fiat Chrysler Automobiles N.V. operates as an international automotive company and is engaged in designing, engineering, manufacturing, distributing and selling vehicles and components and production systems. This Zacks Rank #2 stock has an expected EPS growth rate of 22.4% for 3 to 5 years.

Regal Beloit Corporation (RBC Quick QuoteRBC - Free Report) is a leading manufacturer of electrical and mechanical motion control and power generation products serving markets throughout the world. This Zacks Rank #2 stock has an expected EPS growth rate of 9% for 3 to 5 years.  

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.

Click here to sign up for a free trial to the Research Wizard today.

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.

Zacks Restaurant Recommendations: In addition to dining at these special places, you can feast on their stock shares. A Zacks Special Report spotlights 5 recent IPOs to watch plus 2 stocks that offer immediate promise in a booming sector. Download it free »