The price-to-earnings (P/E) ratio is broadly considered by value investors as a useful yardstick for working out the fair market value of a stock. Many prefer to take the P/E route in their pursuit of a portfolio of stocks with attractive prices. But even this ubiquitously used valuation metric is not without its pitfalls.

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

Although the widespread use of P/E stems from its simplicity, a more-complicated metric called EV/EBITDA is sometimes viewed as a better approach as it offers a clearer picture of a company’s valuation and earnings potential. EV/EBITDA determines the total value of a firm while P/E just considers its 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.

EBITDA, the other element, 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.

Just like P/E, the lower the EV/EBITDA ratio, the more alluring it is. A low EV/EBITDA ratio could be a sign that a stock is potentially undervalued.

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

Another key 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.

EV/EBITDA is also a useful tool in evaluating 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/EBITDA is also not without its downsides and alone cannot conclusively determine a stock’s inherent potential and future performance. The ratio varies across industries and is generally not appropriate while comparing stocks in different industries given their diverse capital spending requirements.

Thus, instead of solely relying on EV/EBITDA, you can club it with the other major ratios such as price-to-book (P/B), P/E and price-to-sales (P/S) to screen bargain 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 14 stocks that passed the screen:

The Greenbrier Companies, Inc. (GBX Quick QuoteGBX - Free Report) is a leading supplier of transportation equipment and services to the railroad and related industries. This Zacks Rank #1 stock has an expected earnings per share (EPS) growth rate of 9.5% for three to five years. It has a Value Score of A.

CIT Group Inc. is a bank holding company that provides financing and leasing capital for commercial companies throughout the world. The stock has an expected year-over-year earnings growth rate of 54.9% for 2017. It currently has a Value Score of B and a Zacks Rank #1. You can see the complete list of today’s Zacks #1 Rank stocks here.

ArcBest Corporation (ARCB Quick QuoteARCB - Free Report) provides freight transportation services and solutions. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 41.9% for 2017. The stock has a Value Score of A.

Prudential Financial, Inc. (PRU Quick QuotePRU - Free Report) is one of the largest financial services institutions in the United States, offering a wide range of insurance, investment management and other financial products and services. The stock has an expected EPS growth rate of 8.5% for three to five years. It currently has a Value Score of A and a Zacks Rank #2.

CVR Refining, LP is engaged in the refining of petroleum primarily in the United States. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 950% for 2017. It has a Value Score of A.

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.

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