Value investors tend to cling to the price-to-earnings (P/E) ratio while looking for stocks that are trading at attractive prices. A widely accepted approach is to chase stocks that flaunt a low P/E ratio. But even this ubiquitously used equity valuation multiple suffers a few drawbacks.

What Makes EV/EBITDA a Better Option?

The popularity of P/E can be attributed to its apparent simplicity. While it is the most commonly used tool for assessing a firm’s value, a more complicated metric called EV/EBITDA does a better job. Also referred to as enterprise multiple, EV/EBITDA offers a clearer picture of a company’s valuation and its earnings potential. While P/E just considers a firm’s equity portion, EV/EBITDA determines its total value.

EV/EBITDA is the enterprise value (EV) of a stock divided by its earnings before interest, taxes, depreciation and amortization (EBITDA). EV is a firm’s market capitalization plus the market value of its debt and preferred equity minus cash. 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 removes 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.

Just like P/E, the lower the EV/EBITDA ratio, the more attractive it is. A low EV/EBITDA ratio could imply that a stock is undervalued.

However, unlike P/E ratio, EV/EBITDA takes debt on a company’s balance sheet into account. Given this reason, EV/EBITDA is generally used to value potential acquisition targets as it shows the amount of debt the acquirer has to assume. 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 firm. A company’s earnings are also subject to accounting estimates and management manipulation. In contrast, EV/EBITDA is difficult to manipulate and can also be used to value companies that are making loss but are EBITDA-positive.

EV/EBITDA also allows the comparison of companies with different debt levels and is a useful tool in measuring the value of firms that are highly leveraged and have substantial depreciation and amortization expenses.

But EV/EBITDA is not devoid of limitations and it alone can’t conclusively determine a stock’s inherent potential and its future performance. It varies across industries and is generally not appropriate while comparing stocks in different industries given their diverse capital spending requirements.

Thus, a strategy entirely based on EV/EBITDA might not yield the desired results.  But you can combine it with other key ratios such as price-to-book (P/B), P/E and price-to-sales (P/S) to screen true value stocks.
 
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:

LG Display Co., Ltd. (LPL Quick QuoteLPL - Free Report) primarily manufactures and sells thin film transistor liquid crystal display (TFT-LCD) panels. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 62.9% for 2017.  

Fiat Chrysler Automobiles N.V. operates as an international automotive company and is engaged in designing, engineering, manufacturing, distributing and selling vehicles, components and production systems. This Zacks Rank #1 stock delivered an average positive earnings surprise of around 39.7% over the trailing four quarters. You can see the complete list of today’s Zacks #1 Rank stocks here.

American Equity Investment Life Holding Company is a full-service underwriter of a broad line of annuity and insurance products, with primary emphasis on the sale of fixed rate and index annuities. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 66.4% for 2017.  

ArcelorMittal (MT Quick QuoteMT - Free Report) is the world's leading steel company, operating a balanced portfolio of cost competitive steel plants across both the developed and developing world. This Zacks Rank #2 stock delivered an average positive earnings surprise of around 143.8% over the trailing four quarters.

Aspen Insurance Holdings Limited is a Bermudian holding company that provides property and casualty reinsurance in the global market, property and liability insurance principally in the UK and surplus lines insurance in the U.S. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 97.4% for 2017.  

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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