The price-to-earnings (P/E) multiple enjoys wide-scale popularity among investors seeking stocks trading at a bargain. In addition to being a widely used tool for screening stocks, P/E is a popular metric to work out the fair market value of a firm. But even this ubiquitously used valuation multiple has a few limitations.

While P/E enjoys great popularity among value investors, a less-used and more-complicated metric called EV-to-EBITDA is sometimes viewed as a better alternative. EV-to-EBITDA gives the true picture of a company’s valuation and earnings potential. It has a more comprehensive approach to valuation.  

Covenant Logistics Group, Inc. (CVLG Quick QuoteCVLG - Free Report) , Group 1 Automotive, Inc. (GPI Quick QuoteGPI - Free Report) , UFP Industries, Inc. (UFPI Quick QuoteUFPI - Free Report) , Plains GP Holdings, L.P. (PAGP Quick QuotePAGP - Free Report) and Motorcar Parts of America, Inc. (MPAA Quick QuoteMPAA - Free Report) are some stocks with attractive EV-to-EBITDA ratios.

Is EV-to-EBITDA a Better Substitute to P/E?

EV-to-EBITDA is essentially 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.

EBITDA, the other component of the multiple, gives a better idea of a company’s profitability as it removes 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-to-EBITDA ratio, the more attractive it is. A low EV-to-EBITDA ratio could signal that a stock is potentially undervalued.  

EV-to-EBITDA takes into account the debt on a company’s balance sheet that the P/E ratio does not. Due to this reason, EV-to-EBITDA is generally used to value the potential acquisition targets as it shows the amount of debt the acquirer has to assume. Stocks boasting a low EV-to-EBITDA multiple could be seen as attractive takeover candidates.

Another shortcoming 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. On the other hand, EV-to-EBITDA is difficult to manipulate and can also be used to value companies making losses but are EBITDA-positive.

EV-to-EBITDA is also a useful yardstick in measuring 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.

But EV-to-EBITDA has its limitations too. The ratio varies across industries (a high-growth industry typically has a higher multiple and vice versa) and is usually not appropriate while comparing stocks in different industries, given their diverse capital requirements.

Thus, a strategy solely based on EV-to-EBITDA might not yield the desired results. But you can club it with the other major ratios in your stock-investing toolbox 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-to-EBITDA 12 Months-Most Recent less than X-Industry Median: A lower EV-to-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 50,000: 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 our five picks out of the 12 stocks that passed the screen:

Covenant Logistics, together with its subsidiaries, offers a portfolio of transportation and logistics services. CVLG, a Zacks Rank #1 stock, has a Value Score of B.

The Zacks Consensus Estimate for Covenant Logistics' current-year earnings has been revised 4.8% upward over the last 60 days. CVLG’s earnings beat the Zacks Consensus Estimate in three of the last four quarters. It has a trailing four-quarter earnings surprise of roughly 12.1%, on average.

Group 1 Automotive is one of the leading automotive retailers in the world. GPI, a Zacks Rank #2 stock, has a Value Score of A. You can see the complete list of today’s Zacks #1 Rank stocks here.

The consensus estimate for Group 1 Automotive’s current-year earnings has been revised 5.7% upward over the past 60 days. GPI’s earnings beat the Zacks Consensus Estimate in each of the last four quarters. It has a trailing four-quarter earnings surprise of roughly 8%, on average.

UFP Industries supplies wood, wood composite and other products in retail, industrial and construction markets. This Zacks Rank #2 stock has a Value Score of A.

The Zacks Consensus Estimate for UFP Industries’ current-year earnings has been revised 0.2% upward over the past 60 days. UFPI beat the Zacks Consensus Estimate for earnings in three of the last four quarters. It has a trailing four-quarter earnings surprise of roughly 11.2%, on average.

Plains GP Holdings, through its subsidiaries, is involved in the transportation, storage, terminalling, and marketing of crude oil and refined products. This Zacks Rank #2 stock has a Value Score of A.

Plains GP Holdings has an expected year-over-year earnings growth rate of 25.6% for the current year. The consensus estimate for PAGP's current-year earnings has been revised 1.9% upward over the past 60 days.

Motorcar Parts of America is a remanufacturer, manufacturer and distributor of automotive aftermarket parts. This Zacks Rank #2 stock has a Value Score of A.

Motorcar Parts of America has an expected year-over-year earnings growth rate of 68.8% for the current fiscal year. The Zacks Consensus Estimate for MPAA's current fiscal earnings has been revised 6.9% upward over the past 60 days.

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.