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Investors generally tend to get fixated on the price-to-earnings (P/E) strategy in their quest for stocks trading at attractive prices. The ratio is broadly considered by value investors as a useful yardstick for assessing the fair market value of a stock. But even this widely popular valuation metric is not without its pitfalls.

What Makes EV/EBITDA a Better Alternative?

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

Also known as the enterprise multiple, EV/EBITDA is the enterprise value (EV) of a stock divided by its earnings before interest, taxes, depreciation and amortization (EBITDA). The first component of the multiple, EV is the sum of a company’s market capitalization, its debt and preferred stock minus cash and cash equivalents.

The other element, EBITDA, gives a better understanding of a company’s profitability as it eliminates the impact of non-cash expenses like depreciation and amortization that dilute net earnings.

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

Unlike the P/E ratio, EV/EBITDA takes debt on a company’s balance sheet into account. For 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 sporting a low EV/EBITDA multiple could be seen as attractive takeover candidates.

Another 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 open 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 measuring the value of companies that are highly leveraged and have a high degree of depreciation. The ratio also allows the comparison of companies with different debt levels.

However, EV/EBITDA is not devoid of limitations and it alone can’t conclusively determine a stock’s inherent potential and its future performance. It varies across industries and is usually not appropriate while comparing stocks in different industries given their diverse capital spending requirements.

Thus, a strategy solely based on EV/EBITDA might not fetch the desired results. But you can club it with other key 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 eight stocks that passed the screen:

The Greenbrier Companies, Inc. (GBX - Free Report) is a leading supplier of transportation equipment and services to the railroad and related industries. This Zacks Rank #2 stock has an expected earnings per share (EPS) growth rate of 9.5% for three to five years. The stock has a Value Score of A.

Preferred Apartment Communities, Inc. (APTS - Free Report) is a real estate investment trust that acquires and operates multifamily properties primarily in the United States. The company has expected year-over-year earnings growth of 169.2% for 2017. It has a Value Score of A and a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.

Caleres, Inc. (CAL - 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. The stock has an expected EPS growth rate of 11% for three to five years. It currently has a Zacks Rank #2 and a Value Score of A.

American Equity Investment Life Holding Company (AEL - 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. It currently has a Zacks Rank #2 and a Value Score of A. The stock has an expected year-over-year earnings growth rate of 81.8% for 2017.

Itron, Inc. (ITRI - Free Report) provides integrated system solutions for collecting, communicating, analyzing and managing information about energy and water usage. The stock delivered an average positive earnings surprise of 14.8% in the trailing four quarters. It currently has a Value Score of B and a Zacks Rank #2.

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.

Click here to sign up for a free trial to the Research Wizard today.

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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