Many investors have a fixation for the price-to-earnings (P/E) strategy in their quest for stocks that are trading at a discount. This is by far the most popular metric used by investors to figure out the fair market value of a firm's equity and is also a widely used tool for screening stocks. But even this ubiquitously used, simple to calculate valuation multiple is not without its flaws.

Is There a Better Alternative to P/E?

The EV/EBITDA ratio, also referred as the enterprise multiple, is often considered better than P/E as it gives a true picture of a company’s valuation and its earning potential. It is essentially the enterprise value (“EV”) of a company divided by its earnings before interest, taxes, depreciation and amortization (”EBITDA”).

EV is a company’s market capitalization plus the market value of its debt and preferred equity minus cash. EBITDA, on the other hand, gives a clearer picture 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.

Typically, the lower the EV/EBITDA ratio, the more appealing it is. Just like P/E, a low EV/EBITDA ratio indicates that a stock is potentially undervalued and vice versa.

Now, the question is, why is the more complicated EV/EBITDA metric a better option than P/E in stock evaluation? The answer lies in the fact that unlike the P/E ratio, EV/EBITDA takes debt on a company’s balance sheet into consideration. This is also the reason why EV/EBITDA is commonly used to value possible acquisition targets. Stocks with a low EV/EBITDA multiple could be seen as attractive takeover candidates.

Moreover, P/E can’t be used to value a loss-making entity. A company’s earnings are also subject to accounting estimates and management manipulation. EV/EBITDA, on the other hand, is harder to manipulate and also can be used to value companies making loss on the net earnings front but are EBITDA-positive.

This ratio determines the total value of a company, not just its equity portion that is solely considered by the P/E ratio. It is a useful tool in assessing the value of firms with a debt-laden balance sheet and a high degree of depreciation. Moreover, it allows comparison of companies with different debt levels.

However, EV/EBITDA is also not without its downsides and it alone can’t conclusively determine a stock’s inherent potential and its future performance.  The multiple varies across industries (a high-growth industry typically has higher EV/EBITDA multiple and vice versa) and is usually not appropriate while comparing companies in different industries given their diverse capital requirements.

So, instead of banking on EV/EBITDA alone, you can club it with other key ratios in your stock investing toolbox such as price-to-book (P/B), P/E and price-to-sales (P/S) to uncover bargain stocks.
 
Screening Criteria

Here are the parameters to screen for true 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 the shares can be traded easily.

Current Price greater than or equal to $5: This parameter will help in screening stocks which 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 outperformed 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 Zacks Rank #1 or 2 offer the best upside potential.

Here are 5 of the 13 stocks that made it through the screen:

Omega Protein Corporation makes products to enhance the nutritional integrity of foods, dietary supplements, and animal feeds globally. This Zacks Rank #1 company delivered an average positive earnings surprise of 25.04% over the trailing four quarters.

Carnival plc (CUK Quick QuoteCUK - Free Report) is a leading cruise company in the world, with a portfolio of 10 cruise brands across North America, Europe, Australia and Asia. This Zacks Rank #2 stock delivered an average positive earnings surprise of 42.23% over the trailing four quarters.

Chemtura Corporation is a global producer of specialty chemicals, crop protection and pool, spa and home care products. This Zacks Rank #2 stock delivered an average positive earnings surprise of 8.40% over the trailing four quarters.

Kulicke and Soffa Industries, Inc. (KLIC Quick QuoteKLIC - Free Report) makes and markets capital equipment and packaging materials for sale to companies that manufacture and assemble semiconductor devices. The company delivered an average positive earnings surprise of 36.12% over the trailing four quarters and carries a Zacks Rank #2.

Argo Group International Holdings, Ltd. underwrites specialty insurance and reinsurance products in the property and casualty market globally. Over the trailing four quarters, this Zacks Rank #2 stock delivered an average positive earnings surprise of 11.86%.

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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