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Investors generally have a fixation on the price-to-earnings (P/E) multiple while seeking stocks that are trading at attractive prices. A widely favored approach by value investors is to chase stocks that have a low P/E ratio. But even this widely popular valuation metric is not without its pitfalls.

Why is EV-to-EBITDA a Better Alternative?

While P/E enjoys great popularity among value investors, a less-used and more-complicated metric called EV-to-EBITDA is sometimes viewed as a better alternative. EV-to-EBITDA gives the true picture of a company’s valuation and earning potential. It has a more comprehensive approach to valuation.  

EV-to-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, debt, and preferred stock minus cash and cash equivalents.

EBITDA, the other component of the multiple, gives a clearer picture 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.

Usually, the lower the EV-to-EBITDA ratio, the more attractive it is. A low EV-to-EBITDA ratio could signal that a stock is potentially undervalued.

EV-to-EBITDA takes into account the debt on a company’s balance sheet that P/E ratio does not. Given this reason, EV-to-EBITDA is usually used to value possible acquisition targets. Stocks with a low EV-to-EBITDA multiple could be seen as potential takeover candidates.

Moreover, P/E can’t be used to value a loss-making firm. A firm’s earnings are also subject to accounting estimates and management manipulation. On the other hand, EV-to-EBITDA is difficult to manipulate and can also be used to value companies that are making loss but are EBITDA-positive.

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

Then again, EV-to-EBITDA has its flaws. It varies across industries (a high-growth industry normally has a higher multiple and vice versa) and is typically not appropriate while comparing stocks in different industries given their diverse capital expenditure requirements.

As such, a strategy solely based on EV-to-EBITDA might not yield the desired results.  But you can club it with the other major ratios in your stock investing toolbox 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-to-EBITDA 12 Months-Most Recent less than X-Industry Median: A lower EV-to-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 14 stocks that passed the screen:

Korea Electric Power Corporation (KEP Quick Quote KEP - Free Report) generates and supplies electric power to its customers, both industrial and residential. This Zacks Rank #1 stock has expected year-over-year earnings growth of 38.4% for the current year and a Value Score of A.

Kelly Services, Inc. (KELYA Quick Quote KELYA - Free Report) is a global leader of providing workforce solutions. This Zacks Rank #2 stock has a Value Score of A. The company beat the Zacks Consensus Estimate for earnings in three of the trailing four quarters at an average of 169.6%. 

TRI Pointe Group, Inc. (TPH Quick Quote TPH - Free Report) is involved in the design, construction, and sale of single-family homes. This Zacks Rank #2 stock has a Value Score of A. The company beat the consensus estimate for earnings in each of the trailing four quarters at an average of 51.6%.

ManpowerGroup Inc. (MAN Quick Quote MAN - Free Report) is one of the leading providers of innovative workforce solutions and services across the globe. This Zacks Rank #2 stock has a Value Score of A. The Zacks Consensus Estimate for current-year earnings for the company has been revised 2.4% upward over the last 60 days.

Global Net Lease, Inc. (GNL Quick Quote GNL - Free Report) is a real estate investment trust. This Zacks Rank #2 stock has a Value Score of B. The consensus estimate for current-year earnings has been revised 6.1% upward over the last 60 days.