The price-to-earnings (P/E) ratio is broadly considered by investors as a yardstick for assessing the fair market value of a stock. The idea of hunting for stocks with a low P/E is ingrained in the minds of many value investors. But even this straightforward, broadly used valuation metric suffers a few downsides.

What Makes EV/EBITDA a Better Alternative?

Although P/E is preferred by many investors while uncovering bargain stocks, another valuation metric called EV/EBITDA does a better job. The ratio is sometimes viewed as a superior substitute as it offers a clearer picture of a firm’s valuation and its earnings potential. EV/EBITDA has a more comprehensive approach to valuation as it determines a firm’s total value. In contrast, P/E just considers a firm’s equity portion.

Also known 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.

EBITDA, the other element, gives the true 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.

Generally, the lower the EV/EBITDA ratio, the more alluring it is. A low EV/EBITDA ratio could signal that a stock is potentially undervalued.  

EV/EBITDA also takes into account the debt on a company’s balance sheet that P/E does not. Due to 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 major drawback of P/E is that it can’t be used to value a loss-making entity. Moreover, a firm’s earnings are subject to accounting estimates and management manipulation. On the other hand, EV/EBITDA is less open to manipulation and can also be used to value companies that are making loss but are EBITDA-positive.

Moreover, EV/EBITDA is a useful tool in assessing the value of companies that are highly leveraged and have a high degree of depreciation. The ratio also allows the comparison of companies with different debt levels.

However, EV/EBITDA is not devoid of limitations 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, a strategy only based on EV/EBITDA might not fetch the desired results. 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 bargain stocks.

 Screening Criteria

Here are the parameters to screen for bargain 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 18 stocks that passed the screen:

Kraton Corporation (KRA - Free Report) is a producer of styrenic block copolymers, specialty polymers and performance products derived from renewable resources. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 25.4% for 2017. It has a Value Score of A.

The Greenbrier Companies, Inc. (GBX - Free Report) is a leading supplier of transportation equipment and services to the railroad and related industries. This Zacks Rank #1 stock has an expected earnings per share (EPS) growth rate of 9.5% for three to five years. The stock has a Value Score of A. You can see the complete list of today’s Zacks #1 Rank stocks here.

Kelly Services, Inc. (KELYA  - Free Report) provides temporary office clerical, marketing, professional, technical, light industrial, home care services, management services, and other business services to a diversified group of customers. This Zacks Rank #1 stock has an expected year-over-year earnings growth rate of 30.8% for 2017 and a Value Score of A.

CVR Refining, LP (CVRR - Free Report) is engaged in the refining of petroleum primarily in the United States. The stock has an expected year-over-year earnings growth rate of a staggering 1,350% for 2017. It currently has a Value Score of A and a Zacks Rank #1.

POSCO (PKX  - Free Report) manufactures hot and cold rolled steel products, heavy plate, and other steel products for the construction and shipbuilding industries. This Zacks Rank #2 stock has an expected year-over-year earnings growth rate of 134.7% for 2017 and a Value Score of A.