Investors are typically fixated on the price-to-earnings (P/E) strategy while seeking stocks trading at attractive prices. This straightforward, easy-to-calculate ratio is the most preferred among all the valuation metrics in the investment toolkit for working out the fair market value of a stock. But even this ubiquitously used valuation metric is not without its pitfalls.

While P/E is the most popular valuation metric, a more complicated multiple called EV-to-EBITDA works even better. Often considered a better alternative to P/E, it gives the true picture of a company’s valuation and earnings potential and has a more complete approach to valuation. While P/E considers a firm’s equity portion, EV-to-EBITDA determines its total value.

KT Corporation KT, Pampa Energia S.A. PAM, Hewlett Packard Enterprise Company HPE, Nomad Foods Limited NOMD and Hamilton Insurance Group, Ltd. HG are some stocks with attractive EV-to-EBITDA ratios.

Is EV-to-EBITDA a Better Substitute to P/E?

EV-to-EBITDA is essentially 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 component of the multiple, gives a better idea of a company’s profitability as it removes the impact of 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-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 the P/E ratio does not. Due to this reason, EV-to-EBITDA is generally used to value the potential acquisition targets as it shows the amount of debt the acquirer has to assume. Stocks boasting a low EV-to-EBITDA multiple could be seen as attractive takeover candidates.

Another shortcoming of P/E is that it can’t be used to value a loss-making firm. A company’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 loss-making but EBITDA-positive companies. EV-to-EBITDA is also a useful tool in measuring the value of firms that are highly leveraged and have a high degree of depreciation. It can be used to compare companies with different levels of debt.

However, EV-to-EBITDA is also not without its shortcomings and alone cannot conclusively determine a stock’s potential and future performance. The ratio varies across industries and is generally not appropriate while comparing stocks in different industries, given their diverse capital spending requirements.

A strategy solely based on EV-to-EBITDA might not yield the desired results. However, 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. 

Average 20-day Volume greater than or equal to 50,000: 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: 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 our five picks out of the eight stocks that passed the screen:

KT is the biggest telecommunications operator in the Republic of Korea. This Zacks Rank #1 stock has a Value Score of A.

KT has an expected earnings growth rate of 20% for 2024. The Zacks Consensus Estimate for KT's 2024 earnings has been revised 8.1% upward over the past 60 days.

Pampa Energia is a leading independent energy-integrated company in Argentina. This Zacks Rank #1 stock has a Value Score of A. You can see the complete list of today’s Zacks #1 Rank stocks here.

Pampa Energia has an expected year-over-year earnings growth rate of 73.5% for 2024. PAM beat the Zacks Consensus Estimate in three of the last four quarters. In this time frame, it has delivered an earnings surprise of roughly 62%, on average.

Hewlett Packard Enterprise is focused on developing solutions that allow customers to capture, analyze and act upon data seamlessly from edge to cloud. This Zacks Rank #2 stock has a Value Score of A.

Hewlett Packard Enterprise’s earnings beat the Zacks Consensus Estimate in each of the last four quarters. It has a trailing four-quarter earnings surprise of roughly 7.5%, on average. The Zacks Consensus Estimate for HPE’s 2024 earnings has been revised 2.1% upward over the past 60 days.

Nomad Foods manufactures and distributes frozen foods primarily in the United Kingdom, Italy, Germany, Sweden, France and Norway. This Zacks Rank #2 stock has a Value Score of A. 

Nomad Foods has an expected year-over-year earnings growth rate of 12.6% for 2024. The Zacks Consensus Estimate for NOMD’s 2024 earnings has been revised 3.2% upward over the last 60 days.

Hamilton Insurance Group is a specialty insurance and reinsurance company that underwrites risks worldwide. This Zacks Rank #2 stock has a Value Score of A. 

Hamilton Insurance Group has an expected earnings growth rate of 72.5% for 2024. The consensus estimate for HG's 2024 earnings has been revised 7.4% upward over the past 60 days.

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.

Click here to sign up for a free trial to the Research Wizard today.

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.

Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free report

KT Corporation (KT) : Free Stock Analysis Report

Pampa Energia S.A. (PAM) : Free Stock Analysis Report

Hewlett Packard Enterprise Company (HPE) : Free Stock Analysis Report

Nomad Foods Limited (NOMD) : Free Stock Analysis Report

Hamilton Insurance Group, Ltd. (HG) : Free Stock Analysis Report

To read this article on Zacks.com click here.

Zacks Investment Research