The price-to-earnings (P/E) ratio, given its apparent simplicity, is the most-preferred one among valuation metrics in the investment toolkit for assessing the fair market value of a stock. The idea of chasing stocks with a low P/E is ingrained in the minds of many value investors. However, even this broadly used equity valuation multiple has a few pitfalls.

What Makes EV/EBITDA a Better Substitute?

Although P/E is the most commonly used tool for evaluating a firm’s value, a more complicated metric called EV/EBITDA does a better job. EV/EBITDA offers a clearer image of a company’s valuation and earnings potential. The ratio also has a more complete approach to valuation as it determines the total value of a firm as opposed to P/E which considers only its equity portion.

EV/EBITDA, also known 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. In essence, it is the full value of a company.

EBITDA, the other element of the ratio, gives a clearer picture of a company’s profitability as it removes the impact of non-cash expenses like depreciation and amortization that depress net earnings. It is also often used as a proxy for cash flows.

Usually, the lower the EV/EBITDA ratio, the more appealing it is. A low EV/EBITDA ratio could signal that a stock is potentially undervalued.  

EV/EBITDA takes into account the debt on a company’s balance sheet that P/E ratio ignores. Due to this reason, EV/EBITDA is generally used to value potential acquisition targets as 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 downside 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 amenable 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 tool in assessing the value of firms with high balance sheet leverage and substantial depreciation and amortization expenses. It also can be used to compare companies with different levels of debt.

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

As such, instead of solely banking on EV/EBITDA, 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 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 Value 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:

Acushnet Holdings Corp. (GOLF Quick QuoteGOLF - Free Report) designs, develops, manufactures and distributes golf products. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 73.8% for 2017. It has a Value Score of A.

The Greenbrier Companies, Inc. (GBX Quick QuoteGBX - Free Report) is a leading supplier of transportation equipment and services to the railroad and related industries. The stock has an expected earnings per share (EPS) growth rate of 9.5% for three to five years. It currently has a Value Score of A and a Zacks Rank #1. You can see the complete list of today’s Zacks #1 Rank stocks here.

Kelly Services, Inc. (KELYA Quick QuoteKELYA - Free Report) provides temporary office clerical, marketing, professional, technical, light industrial, home care services, management services and other business services to a diversified group of customers. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 30.8% for 2017 and a Value Score of A.

CVR Refining, LP is engaged in the refining of petroleum primarily in the United States. The stock has an expected year-over-year earnings growth rate of a whopping 1,430% for 2017. It currently has a Value Score of A and a Zacks Rank #1.

Huntsman Corporation (HUN Quick QuoteHUN - Free Report) is among the world's largest global manufacturers of differentiated and commodity chemical products for a variety of industrial and consumer applications. This Zacks Rank #2 stock has an expected EPS growth rate of 8% for three to five years. It has a Value Score of A.

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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