Investors typically have a fixation for the price-to-earnings (P/E) strategy in their quest for stocks that are trading at bargain prices. A widely favored approach by value investors is to chase stocks that have a low P/E ratio. But even this straightforward, broadly used valuation metric suffers a few downsides.

EV/EBITDA is a Better Approach, Here’s Why

While P/E is preferred by many investors while uncovering bargain stocks, another valuation metric called EV/EBITDA does a better job. The ratio is often viewed as a better option as it offers a clearer picture of a company’s valuation and earnings potential. Unlike P/E that solely considers a company’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 the sum of a company’s market capitalization, its debt and preferred stock minus cash and cash equivalents. In a nutshell, it is the entire value of a company.

EBITDA, the other element, gives a true reflection of a company’s profitability as it removes 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.

Typically, the lower the EV/EBITDA ratio, the better it is. A low EV/EBITDA ratio could signal that a stock is potentially undervalued.

EV/EBITDA takes into account the debt on a company’s balance sheet which the P/E ratio does not. For 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.

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

EV/EBITDA is also a useful tool in assessing the value of firms that are highly leveraged and have a high degree of depreciation. It also can be used to compare companies with different levels of debt.

But EV/EBITDA has its downsides too. It varies across industries and is generally not appropriate while comparing stocks in different industries given their diverse capital spending requirements.

Thus, a strategy only based on EV/EBITDA might not fetch the desired outcome. But you can combine it with other major ratios 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/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 Value Score of A or B when combined with a Zacks Rank #1 or 2 offer the best upside potential.

Here are five of the 15 stocks that passed the screen:

Verso Corporation produces coated freesheet, coated ground wood and uncoated super calendared papers and pulp. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 434.7% for 2018 and a Value Score of A.

Covenant Transportation Group, Inc. is a truckload carrier that offers just-in-time and other premium transportation service throughout the United States. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 116.7% for 2018 and a Value Score of A. You can see the complete list of today’s Zacks #1 Rank stocks here.

Darling Ingredients Inc. (DAR Quick QuoteDAR - Free Report) is a provider of rendering, cooking oil and bakery waste recycling and recovery solutions. The stock has an expected year-over-year earnings growth rate of 316.7% for 2018. It currently has a Value Score of A and a Zacks Rank #2.

Ingles Markets, Inc. (IMKTA Quick QuoteIMKTA - Free Report) is a leading supermarket chain with operations in Southeast United States. This Zacks Rank #2 stock has an expected earnings per share (EPS) growth rate of 3.2% for three to five years and a Value Score of B.

Exelon Corporation (EXC Quick QuoteEXC - Free Report) is a utility services holding company. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 18.1% for 2018. It also has a Value Score of B.

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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