Price-to-earnings (P/E) is by far the most popular metric used by investors to work out the fair value of a stock. Many prefer to take the P/E route in their pursuit of a portfolio of stocks with attractive prices. In fact, the idea of chasing stocks with a low P/E is ingrained in the minds of many value investors. However, even this easy-to-compute, widely used metric is not without its pitfalls.

EV/EBITDA is a Better Approach, Here’s Why

No doubt P/E enjoys great popularity among value inventors. But a more complicated and less used metric called EV/EBITDA is sometimes viewed as a better alternative as it offers a clearer picture of a firm’s valuation and its earnings potential.

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. Essentially, it is the entire value of a company.

EBITDA, the other component of the ratio, gives the true 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 imply that a stock is potentially undervalued and vice versa.

Also referred to as the enterprise multiple, EV/EBITDA takes a more complete approach to valuation. It takes into account the debt on a company’s balance sheet that P/E ratio ignores. This is the reason why EV/EBITDA is typically used to value potential acquisition targets. It shows the amount of debt the acquirer has to bear. Stocks boasting a low EV/EBITDA multiple could be seen as attractive takeover candidates.

Another flaw of P/E is that it can’t be used to value a loss-making firm. Moreover, a company’s earnings are subject to accounting estimates and management manipulation. On the contrary, EV/EBITDA is less susceptible to manipulation and can also be used to value firms that have negative net earnings but are positive at the EBITDA level.

EV/EBITDA also determines the total value of a company while P/E solely considers its equity portion. EV/EBITDA is also a useful tool in measuring the value of companies with highly leveraged balance sheets and substantial depreciation and amortization expenses. It also can be used to compare companies with different levels of debt.

However, EV/EBITDA is too not devoid of drawbacks. The ratio varies across industries (a high-growth industry typically has higher multiple) and is usually not appropriate for comparing stocks in different industries due to their diverse capital expenditure requirements.

So, 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 achieve the desired outcome.

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 10 stocks that passed the screen:

Amkor Technology, Inc. (AMKR Quick QuoteAMKR - Free Report) is a leading provider of semiconductor packaging and test services. Moreover, the company is one of the leading developers of advanced semiconductor packaging and test technology. This Zacks Rank #1 stock has expected year-over-year earnings growth of 29.4% for 2016 and 40.9% for 2017.

Comfort Systems USA Inc. (FIX Quick QuoteFIX - Free Report) is a national provider of comprehensive heating, ventilation and air conditioning installation, maintenance, repair and replacement services. This Zacks Rank #2 company delivered an average positive earnings surprise of around 28.2% over the trailing four quarters.

Celestica Inc. (CLS Quick QuoteCLS - Free Report) is one of the largest electronics manufacturing services company in the world, serving the computer, and communications sectors. This Zacks Rank #2 stock has expected year-over-year earnings growth of 26.5% for 2016 and 3.5% for 2017.

OFG Bancorp (OFG Quick QuoteOFG - Free Report) is a financial holding company that conducts its business activities through its subsidiaries, primarily in Puerto Rico. This Zacks Rank #2 stock has expected year-over-year earnings growth of a whopping 379.7% for 2016.

Principal Financial Group Inc. (PFG Quick QuotePFG - Free Report) is a leading provider of retirement savings, investment and insurance products and services. The company carries a Zacks Rank #2 and has an expected EPS growth rate of 6.5% 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.

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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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