Price-to-earnings (P/E) is hands down the most commonly used metric in the value investing world. The ratio enjoys greater popularity among valuation metrics in the investment toolkit and is preferred while uncovering stocks trading at attractive prices. A widely favored approach by value investors is to chase stocks with a low P/E ratio. But even this equity valuation multiple is not devoid of shortcomings.

Why EV/EBITDA is a Better Alternative?

While P/E is by far the most-popular valuation metric, a more-complicated metric called EV/EBITDA does a better job in working out the fair market value of a firm. Often viewed as a better substitute to P/E, this ratio offers a clearer picture of a company’s valuation and its earnings potential.

Also dubbed 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.

The other element of the ratio, EBITDA 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.

Just like P/E, the lower the EV/EBITDA ratio, the more appealing it is. A low EV/EBITDA ratio could be a sign that a stock is potentially undervalued.

However, unlike P/E ratio, EV/EBITDA takes into account the debt on a company’s balance sheet. For this reason, EV/EBITDA is usually used to value possible acquisition targets. Stocks with a low EV/EBITDA multiple could be seen as potential takeover candidates.

Another key drawback of P/E is that it cannot be used to value a loss-making entity. A firm’s earnings are also subject to accounting estimates and management manipulation. In contrast, 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 firms that are highly leveraged and have a high degree of depreciation. Moreover, it can be used to compare companies with different levels of debt.

However, EV/EBITDA is also not without shortcomings and it alone can’t conclusively determine a stock’s inherent potential and its future performance. The multiple varies across industries and is generally not appropriate for comparing stocks in different industries due to their diverse capital requirements.

Thus, instead of solely banking on EV/EBITDA, you can club it with other key ratios in your stock investment toolkit such as price-to-book (P/B), P/E and price-to-sales (P/S) to uncover 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 13 stocks that passed the screen:

Big Lots, Inc. (BIG - Free Report) , through its fully owned subsidiaries, is a discount retailer operating in the United States. This Zacks Rank #1 stock has expected year-over-year earnings growth of 21% for the current fiscal year and a Value Score of A.

B&G Foods, Inc. (BGS - Free Report) , along with its subsidiaries, manufactures, sells and distributes high quality, shelf stable, frozen food and household products. This Zacks Rank #1 company has an expected year-over-year earnings growth rate of 21.3% for the current year and a Value Score of A. 

Oasis Midstream Partners LP (OMP - Free Report) is a master limited partnership that owns, develops, operates and acquires a diversified portfolio of midstream assets in North America. This Zacks Rank #1 stock has a Value Score of A. The company beat the Zacks Consensus Estimate for earnings in three of the trailing four quarters, the average being 32.1%.

Amkor Technology, Inc. (AMKR - Free Report) is one of the largest providers of semiconductor packaging and test services. This Zacks Rank #1 company has an expected year-over-year earnings growth rate of 25% for the current year and a Value Score of B.

Vistra Energy Corp. (VST - Free Report) is a leading, integrated, energy company providing essential resources for customers, commerce and communities. This Zacks Rank #2 stock has expected year-over-year earnings growth of 23.2% for the current year and a Value Score of A.