Investors generally tend to cling to the price-to-earnings (P/E) metric while looking for bargain stocks. In addition to being a widely used tool for screening stocks, P/E is also a popular metric to work out the fair market value of a company. However, even this universally used valuation multiple is not without its limitations.

Is EV/EBITDA a Better Alternative to P/E?

While P/E is hands down the most popular equity evaluation ratio, another valuation metric called EV/EBITDA works even better. This ratio is often viewed as a better alternative to P/E as it offers a clearer picture of a company’s valuation and its earnings potential. Also referred as the enterprise multiple, it 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. Simply put, it is the total value of a firm. EBITDA, the other element of the ratio, is a true reflection of a company’s profitability as it strips out non-cash expenses like depreciation and amortization that reduce net earnings. It is also often used as a proxy for cash flows.

Just like P/E, the lower the EV/EBITDA ratio, the better it is. A low EV/EBITDA ratio could signal 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 drawback of P/E is that it can’t be used to value a loss-making company. Moreover, a firm’s earnings are 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.

In addition, while P/E ratio only considers the equity portion of a firm, EV/EBITDA determines the total value of a company. 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 a high degree of depreciation.

So while EV/EBITDA is a more complicated metric, it is also a more comprehensive one than P/E in stock evaluation.

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

As such, a strategy solely based on EV/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 true value 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 the shares can be traded easily.

Current Price greater than or equal to $5: This parameter will help in screening stocks which 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 outperformed 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 10 stocks that made it through the screen:

Preferred Apartment Communities, Inc. APTS is a real estate investment trust that acquires and operates multifamily properties primarily in the U.S. This Zacks Rank #1 company delivered an average positive earnings surprise of 3.5% over the trailing four quarters.

Genesco Inc. GCO is a specialty retailer that sells footwear, headwear and accessories in retail stores in the U.S. and Canada. This Zacks Rank #2 stock delivered an average positive earnings surprise of 26.44% over the last four quarters.

Qiwi plc QIWI operates as a provider of next generation payment services mainly in Russia and the CIS. This Zacks Rank #2 stock delivered an average positive earnings surprise of 12.15% over the trailing four quarters.

Companhia de Saneamento Basico do Estado de Sao Paulo SBS provides public water and sewage services to residential, commercial, industrial and governmental customers in Sao Paulo. This Zacks Rank #2 stock has expected year- over-year earnings growth of 195.83% for 2016 and 10.80% for 2017.

Tech Data Corp. TECD is a leading provider of Internet technology products, logistics management and other value-added services. The company delivered an average positive earnings surprise of 14.71% over the trailing four quarters and carries a Zacks Rank #2.