The price-to-earnings (P/E) multiple enjoys wide-scale popularity among investors seeking stocks trading at a bargain. In addition to being a widely used tool for screening stocks, P/E is a popular metric to work out the fair market value of a firm. But even this ubiquitously used valuation multiple has a few limitations.

Although P/E is the most popular valuation metric, a more complicated multiple called EV-to-EBITDA works even better. Often considered a better alternative to P/E, it gives the true picture of a company’s valuation and earnings potential, and has a more complete approach to valuation. While P/E considers a firm’s equity portion, EV-to-EBITDA determines its total value.

Titan Machinery Inc. (TITN Quick QuoteTITN - Free Report) , PVH Corp. (PVH Quick QuotePVH - Free Report) , Unum Group (UNM Quick QuoteUNM - Free Report) , AAR Corp. (AIR Quick QuoteAIR - Free Report) and Valero Energy Corporation (VLO Quick QuoteVLO - Free Report) are some stocks with attractive EV-to-EBITDA ratios.

What Makes EV-to-EBITDA a Better Alternative?

EV-to-EBITDA is essentially 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.

The other component of the multiple, EBITDA, gives a better idea of a company’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.

Just like P/E, the lower the EV-to-EBITDA ratio, the more attractive it is. A low EV-to-EBITDA ratio could signal that a stock is potentially undervalued.  

EV-to-EBITDA takes into account the debt on a company’s balance sheet that P/E ratio does not. Due to this reason, EV-to-EBITDA is generally used to value the potential acquisition targets as it shows the amount of debt the acquirer has to assume. Stocks boasting a low EV-to-EBITDA multiple could be seen as attractive takeover candidates.

Another shortcoming of P/E is that it can’t be used to value a loss-making firm. A company’s earnings are also subject to accounting estimates and management manipulation. On the other hand, EV-to-EBITDA is difficult to manipulate and can also be used to value companies making losses but are EBITDA-positive.

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

However, EV-to-EBITDA is not devoid of shortcomings and alone cannot conclusively determine a stock’s inherent potential and future performance. The multiple varies across industries and is usually not appropriate while comparing stocks in different industries, given their diverse capital expenditure requirements.

Hence, a strategy entirely based on EV-to-EBITDA might not yield the desired results. But you can club 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-to-EBITDA 12 Months-Most Recent less than X-Industry Median: A lower EV-to-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 our five picks out of the 12 stocks that passed the screen:

Titan Machinery operates a network of full-service agricultural and construction equipment dealer locations in North America and Europe. This Zacks Rank #1 stock has a Value Score of B.

Titan Machinery has an expected year-over-year earnings growth rate of 11.9% for the current fiscal year. TITN’s earnings beat the Zacks Consensus Estimate in three of the last four quarters. It has a trailing four-quarter earnings surprise of roughly 18.5%, on average.

PVH specializes in designing and marketing branded dress shirts, neckwear, sportswear, jeanswear, intimate apparel, swim products, footwear, handbags and related products. This Zacks Rank #2 stock has a Value Score of A. You can see the complete list of today’s Zacks #1 Rank stocks here.

PVH has an expected year-over-year earnings growth rate of 15.2% for the current fiscal year. The Zacks Consensus Estimate for PVH’s current fiscal-year earnings has been revised 3.1% upward over the past 60 days.

Unum Group provides long-term care insurance, life insurance, employer- and employee-paid group benefits and related services. This Zacks Rank #2 stock has a Value Score of A.

Unum Group has an expected year-over-year earnings growth rate of 24.5% for the current year. The Zacks Consensus Estimate for UNM’s current-year earnings has been revised 1.8% upward over the last 60 days.

AAR provides various products and services to the aviation and defense industries worldwide. AIR, a Zacks Rank #2 stock, has a Value Score of A.

AAR has an expected year-over-year earnings growth rate of 21.3% for the current fiscal year. The consensus estimate for AIR’s current fiscal-year earnings has been revised 0.3% upward over the last 60 days.

Valero Energy is the largest independent refiner and marketer of petroleum products in the United States. This Zacks Rank #2 stock has a Value Score of A.

The Zacks Consensus Estimate for Valero Energy’s current-year earnings has been revised 13% upward over the past 60 days. VLO’s earnings beat the Zacks Consensus Estimate in each of the last four quarters at an average of 9%.

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.

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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.