Investors typically have a fixation for the price-to-earnings (P/E) strategy in their quest for stocks that are trading at bargain prices. Without doubt, P/E is the most popular metric for working out the fair market value of a stock. However, even this widely used valuation multiple is not devoid of shortcomings.

What Makes EV/EBITDA a Better Alternative?

The popularity of P/E stems from its simplicity. However, a more complicated and less used metric called EV/EBITDA is often viewed as a better alternative as it offers a clearer picture of a company’s valuation and earnings potential. EV/EBITDA has a more complete approach to valuation as it determines a firm’s total value. In contrast, P/E just considers a firm’s 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. Essentially, it is the full value of a company.

The other constituent, 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. It is also often used as a proxy for cash flows.

Just like P/E, the lower the EV/EBITDA ratio, the more attractive it is. A low EV/EBITDA ratio could signal 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 multiple varies across industries (a high-growth industry generally has higher multiple) and is usually not appropriate while comparing stocks in different industries given their diverse capital requirements.

Thus, instead of solely relying on EV/EBITDA, you can combine 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 Style Score of ‘A’ or ‘B’ when combined with a Zacks Rank #1 or 2 offer the best upside potential.

Here are five of the 12 stocks that passed the screen:

POSCO (PKX Quick QuotePKX - Free Report) makes hot and cold rolled steel products, heavy plate and other steel products for the construction and shipbuilding industries. This Zacks Rank #1 stock has a staggering 857.1% expected year-over-year earnings growth for 2016.

TTM Technologies Inc. (TTMI Quick QuoteTTMI - Free Report) offers time-critical, one-stop manufacturing services for highly complex printed circuit boards. Its printed circuit boards serve as the foundation of electronic products such as routers, switches, computer memory modules and communications infrastructure equipment. This Zacks Rank #1 stock delivered an average positive earnings surprise of around 29% over the trailing four quarters.

PennyMac Financial Services, Inc. (PFSI Quick QuotePFSI - Free Report) provides financial services primarily in the U.S. This Zacks Rank #1 stock has an expected EPS growth rate of 10% for 3 to 5 years. You can see the complete list of today’s Zacks #1 Rank stocks here.

Amkor Technology, Inc. (AMKR Quick QuoteAMKR - Free Report) is a leading provider of semiconductor packaging and test services. Moreover, the company is one of the leading developers of advanced semiconductor packaging and test technology. This Zacks Rank #1 stock has expected year-over-year earnings growth of 55.9% for 2016 and 50.9% for 2017.

Cosan Limited is the leading global ethanol and sugar company in terms of production with low-cost, large-scale and integrated operations in Brazil. This Zacks Rank #2 stock has an expected EPS growth rate of 15.7% for 3 to 5 years.

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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