The price-to-earnings (P/E) ratio is widely considered by value investors as a useful tool to work out the fair value of a stock. Many prefer to take the P/E route in their quest for a portfolio of stocks with attractive prices. However, even this broadly used valuation multiple is not devoid of limitations.

EV/EBITDA is a Better Alternative, But Why?

While P/E is by far the most popular metric used by investors, a more complicated and less used metric called EV/EBITDA is sometimes viewed as a better alternative. This ratio offers a clearer picture of a company’s valuation and its earnings potential.

EV/EBITDA, also known as enterprise multiple, is the enterprise value (EV) of a stock divided by its earnings before interest, taxes, depreciation and amortization (EBITDA). The first component of the ratio, EV, is a firm’s market capitalization plus the market value of its debt and preferred equity minus cash. Essentially, it is the entire value of a company.

The other element, EBITDA, gives the true picture of a firm’s profitability as it eliminates the impact of 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. A low EV/EBITDA ratio could signal that a stock is undervalued.

EV/EBITDA determines the total value of a firm while P/E just considers its equity portion. Unlike P/E ratio, it takes debt on a company’s balance sheet into account. Due to this reason, EV/EBITDA is typically used to value potential acquisition targets as it shows the amount of debt the acquirer has to bear. Stocks sporting low EV/EBITDA multiple could be seen as attractive takeover candidates.

Another major drawback of P/E is that it can’t be used to value a loss-making firm. Moreover, a company’s earnings are also subject to accounting estimates and management manipulation. On the other hand, EV/EBITDA is harder to manipulate and can also be used to value companies that have negative net earnings but are positive on the EBITDA front.

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

However, EV/EBITDA is not without its flaws and it alone can’t conclusively determine a stock’s inherent potential and its future performance. The ratio varies across industries and is generally not appropriate while comparing stocks in different industries given their diverse capital spending requirements.

As such, 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 achieve the desired results.
 
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 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 13 stocks that passed the screen:

Prudential Financial, Inc. (PRU Quick QuotePRU - Free Report) is one of the largest financial services institutions in the U.S. This Zacks Rank #2 stock has an expected EPS growth rate of 8.5% for 3 to 5 years.

Embraer S.A. (ERJ Quick QuoteERJ - Free Report) is a customer-oriented company with experience in designing, manufacturing, selling and supporting aircraft for the world's commercial and defense markets. This Zacks Rank #2 stock has an expected year-over-year earnings growth of 39% for 2017.  

Regions Financial Corporation (RF Quick QuoteRF - Free Report)   is a regional bank holding company and has banking-related subsidiaries engaged in mortgage banking, credit life insurance, leasing, and securities brokerage activities with offices in various Southeastern states. This Zacks Rank #2 stock has an expected EPS growth rate of 9.9% for 3 to 5 years. You can see the complete list of today’s Zacks #1 Rank stocks here.

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. This Zacks Rank #2 stock delivered an average positive earnings surprise of around 54.6% over the trailing four quarters.

Summit Hotel Properties, Inc. (INN Quick QuoteINN - Free Report) is a publicly traded real estate investment trust focused mainly on owning premium-branded, select-service hotels in the upscale and upper midscale segments of the lodging industry. This Zacks Rank #2 stock delivered an average positive earnings surprise of around 11.7% over the trailing four quarters.

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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