Investors generally have a fixation for the price-to-earnings (P/E) strategy while seeking stocks trading at attractive prices. This straight-forward, easy-to-calculate ratio is the most preferred among the valuation metrics in the investment toolkit for working out the fair market value of a stock. But even this ubiquitously used valuation metric is not without its pitfalls.

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

While the popularity of P/E stems from its simplicity, a more complicated and less-used metric called EV/EBITDA is often viewed as a better option as it offers a clearer picture of a company’s valuation and earnings potential. EV/EBITDA has a more complete approach to valuation as it determines a firm’s total value. In contrast, P/E only considers a firm’s equity portion.

Also referred to as enterprise multiple, EV/EBITDA 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 EBITDA, the other constituent, gives a clearer picture of a company’s profitability as it strips out 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.

Generally, the lower the EV/EBITDA ratio, the more enticing it is. A low EV/EBITDA ratio could indicate that a stock is potentially undervalued.  

Unlike P/E ratio, EV/EBITDA takes debt on a company’s balance sheet into account. Given 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 major drawback 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 manipulation and can also be used to value companies that are making loss but are EBITDA-positive.

Moreover, EV/EBITDA is a useful tool in evaluating the value of companies with high balance sheet leverage and considerable depreciation and amortization expenses. It also can be used to compare companies with different levels of debt.

However, EV/EBITDA has its limitations too. It varies across industries and is generally not appropriate while comparing stocks in different industries given their diverse capital spending requirements.

Hence, a strategy entirely based on EV/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/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:

ArcelorMittal (MT Quick QuoteMT - Free Report) is the world's leading steel company, operating a balanced portfolio of cost competitive steel plants across both the developed and developing world. This Zacks Rank #1 stock has an expected earnings per share (EPS) growth rate of 10.9% for 3 to 5 years. You can see the complete list of today’s Zacks #1 Rank stocks here.

American Equity Investment Life Holding Company (AEL Quick QuoteAEL - Free Report) is a full-service underwriter of a broad line of annuity and insurance products, with primary emphasis on the sale of fixed rate and index annuities. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 66.4% for 2017.

Darling Ingredients Inc. (DAR Quick QuoteDAR - Free Report) is a provider of rendering, cooking oil and bakery waste recycling and recovery solutions. This Zacks Rank #2 stock has expected year-over-year earnings growth of 12.2% for 2017.

Fiat Chrysler Automobiles N.V. operates as an international automotive company and is engaged in designing, engineering, manufacturing, distributing and selling vehicles, components and production systems. This Zacks Rank #2 stock delivered an average positive earnings surprise of around 39.7% in the trailing four quarters.

Preferred Apartment Communities, Inc.   is a real estate investment trust that acquires and operates multifamily properties primarily in the U.S. This Zacks Rank #2 stock has expected year-over-year earnings growth of 12.2% for 2017.

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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