The price-to-earnings (P/E) multiple, due to its simplicity, enjoys huge popularity among investors looking for stocks that are trading at a discount. A widely favored approach by value investors is to chase stocks that have a low P/E ratio. However, even this straightforward, easy-to-compute, multiple is not without its shortcomings.

Why EV/EBITDA is a Better Substitute to P/E?

While P/E is undoubtedly the most coveted metric in the value investing world, a more complicated metric called EV/EBITDA does a better job in working out the fair market value of a firm. Sometimes viewed as a better alternative to P/E, EV/EBITDA offers a clearer picture of a company’s valuation and its earnings potential. EV/EBITDA also has a more complete approach to valuation as it determines the total value of a firm as opposed to P/E which just considers its equity portion.  

EV/EBITDA, also referred to as enterprise multiple, is the enterprise value (EV) of a stock divided by its earnings before interest, taxes, depreciation and amortization (EBITDA). EV is a firm’s market capitalization plus the market value of its debt and preferred equity minus cash. In a nutshell, it is the total value of a company.

The other element of the ratio, EBITDA, gives a clearer picture of a company’s profitability as it eliminates 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.

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 does not. 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 assume. Stocks flaunting 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. On the contrary, EV/EBITDA is less open to manipulation and can also be used to value companies that are making loss but are EBITDA-positive.

EV/EBITDA is also a useful tool in measuring the value of companies 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 is not without its limitations. It varies across industries and is generally not appropriate while comparing stocks in different industries given their diverse capital spending requirements.

Thus, 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 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 17 stocks that passed the screen:

Nippon Telegraph and Telephone Corporation offers a range of telecommunications services, including telephone, telegraph, leased circuits, data communication, terminal equipment sales and other services. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 17.5% for 2017.  

Tech Data Corporation is a leading provider of Internet technology products, logistics management and other value-added services. This Zacks Rank #1 stock has an expected earnings per share (EPS) growth rate of 22.8% for 3 to 5 years. You can see the complete list of today’s Zacks #1 Rank stocks here.

Big 5 Sporting Goods Corporation (BGFV Quick QuoteBGFV - Free Report) is a leading sporting goods retailer in the western U.S., operating stores under the name Big 5 Sporting Goods. This Zacks Rank #1 stock has an expected EPS growth rate of 12% for 3 to 5 years.
 
Plains GP Holdings, L.P. (PAGP Quick QuotePAGP - Free Report) , through its subsidiaries, is involved in the transportation, storage, terminalling, and marketing of crude oil and refined products. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 196% for 2017.  

Caleres, Inc. (CAL Quick QuoteCAL - Free Report) is a footwear retailer and wholesaler, involved in the operation of retail shoe stores and e-commerce Websites as well as the design, sourcing and marketing of footwear for women and men. This Zacks Rank #2 stock has an expected EPS growth rate of 11% 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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