Value investors typically tend to get fixated on the price-to-earnings (P/E) strategy while looking for stocks that are trading at a bargain. P/E, without a shadow of a doubt, is the most popular multiple used by investors for assessing the fair market value of a stock. But even this widely popular valuation metric suffers a few drawbacks.

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

While the popularity of P/E stems from its simplicity, another valuation 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.

While EV/EBITDA is a more complicated metric, it is also more comprehensive than P/E in stock evaluation. EV/EBITDA determines the total value of a company, while P/E solely considers its equity portion.

Also referred to 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). EV is the sum of a company’s market capitalization, its debt and preferred stock minus cash and cash equivalents. Simply put, it is the total value of a firm.

EBITDA, the other component of the ratio, is a true reflection of a company’s profitability as it eliminates non-cash expenses like depreciation and amortization that depress net earnings. It is also often used as a proxy for cash flows.

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

EV/EBITDA takes debt on a company’s balance sheet into account that P/E does not. Due to this reason, EV/EBITDA is typically used to value possible acquisition targets, as it shows the amount of debt the acquirer has to assume. Companies with 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 firm. A company’s earnings are also subject to accounting estimates and management manipulation. In comparison, EV/EBITDA is less amenable to manipulation and can also be used to value firms that have negative net earnings but are positive on the EBITDA front.

EV/EBITDA is also a useful tool in measuring the value of companies that are highly leveraged and have a high degree of depreciation. Moreover, the ratio allows the comparison of companies with different debt levels.

However, EV/EBITDA is also not without its downsides and alone can’t 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 key 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 bargain 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:

SUPERVALU Inc. is one of the largest grocery wholesalers and retailers in the United States. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 19.7% for fiscal 2018 and a Value Score of A.

Unum Group (UNM Quick QuoteUNM - Free Report) is the industry leader in disability income protection and one of the top providers of supplemental benefits in the United States. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 20.8% for 2018 and a Value Score of A. You can see the complete list of today’s Zacks #1 Rank stocks here.

Covenant Transportation Group, Inc. is a truckload carrier that offers just-in-time and other premium transportation services throughout the United States. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 113.1% for 2018 and a Value Score of A.

Darling Ingredients Inc. (DAR Quick QuoteDAR - Free Report) is a provider of rendering, cooking oil and bakery waste recycling and recovery solutions. The stock has an expected year-over-year earnings growth rate of 316.7% for 2018. It currently has a Value Score of A and a Zacks Rank #2.

Comfort Systems USA, Inc. (FIX Quick QuoteFIX - Free Report) is a provider of comprehensive heating, ventilation and air conditioning installation, maintenance, repair and replacement services. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 37.4% for 2018 and a Value Score of B.

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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