If learning how to invest were compared to learning the piano, then the price-to-earnings ratio is "Mary Had a Little Lamb" -- it's simple, easy to pick up, and it's one of the first things you learn. Of course it's also something that may not be worth using ever again.
At least that's the exaggerated version of one of the central conclusions in a recent paper from Drexel University's Wesley Gray and Jack Vogel.
The pair tackled a key area of concern for investors -- valuation metrics -- and kicked it off by going after a conclusion by finance research legends Gene Fama and Ken French. Fama and French are well known because their research allowed countless value investors to finally point to academic research that showed proof for what they already intuitively knew -- that value investing works.
However, while Fama and French gave good reason to pick value stocks over their more expensive counterparts, they weren't as concerned with which valuation metric you use. In fact, they said:
We always emphasize that different price ratios are just different ways to scale a stock's price with a fundamental, to extract the information in the cross-section of stock prices about expected returns. One fundamental (book value, earnings, or cashflow) is pretty much as good as another for this job, and the average return spreads produced by different ratios are similar to and, in statistical terms, indistinguishable from one another.
In other words, use whichever valuation metric you want because it really doesn't matter. Gray and Vogel's response: "Umm... no, not so much."
By mashing up close to 40 years of stock market data, Gray and Vogel reached the conclusion that total enterprise value, or TEV, over EBITDA was the most reliable metric for finding market outperformance among value stocks. The average annual return for the cheapest TEV/EBITDA stocks delivered average annual performance of 17.7% versus 15.2% for P/E and 15% for price-to-book value.
Notably, the researchers stripped out financial and utility stocks for their study, so don't rely on these conclusions for those stocks (TEV/EBITDA doesn't make sense for financial stocks anyway).
EBITDA: It's not what you think
You'd sure like 17.7% annual returns -- we all would. But if you remember the dotcom crash at all, then you probably remember that EBITDA became a running joke as the measure was twisted, stretched, and otherwise manipulated to mean anything that a company wanted it to as long as it made the unprofitable company in question look profitable.
But while EBITDA can clearly be usurped for evil, it can also be used for good. The measure -- which breaks down to operating income plus depreciation and amortization plus non-operating income -- can act as a stand-in for cash flow, and, for obvious reasons, investors should love cash flow.
So while EBITDA may be intimidating to some (What the heck are all of those letters?) and bring back bad memories for others (Didn't Enron rely on EBITDA?), there's nothing wrong with safe, sober use of the metric. In fact, as Gray and Vogel show us, it's quite the contrary -- it'd be a mistake to not consider EBTIDA-based valuations.
Where to? Your current best bets
Now that we've established that it's TEV/EBITDA that we should be looking at, I can't leave you without some thoughts on what stocks this metric would direct you toward. For our purposes, I sliced up the Dow Jones (INDEX: ^DJI) index, removing the financial companies and then chopping it up into quintiles. And the cheapest by TEV/EBITDA? Let's take a look:
Total Enterprise Value
Cisco Systems (NAS: CSCO)
ExxonMobil (NYS: XOM)
Hewlett-Packard (NYS: HPQ)
Intel (NAS: INTC)
Source: S&P Capital IQ.
This group wouldn't make a well-diversified portfolio -- Chevron and Exxon are both energy giants while Cisco, HP, and Intel are all tech names. And Cisco and HP may set off warning bells for investors as they're two companies that have had some very real business struggles lately that are helping drive the low valuations. Intel, on the other hand, is not only one of my personal portfolio holdings, but one of my favorite dividend stocks, period.
But a value-oriented investment approach often isn't about finding the companies that everyone thinks are superb at the moment -- all too often those excitement-laden companies end up in the higher-price segments of the market that don't end up performing as well. Instead, the idea is to understand that sometimes investors get overwhelmed by bad events, get too pessimistic, and are willing to sell shares well below their true value.
I've given all five of the stocks above a thumbs-up in my Motley Fool CAPS portfolio and think all are at least worth being on your radar. To check out one more stock that my fellow Fools think is part of the "next trillion-dollar revolution" and is trading at a below-market TEV/EBITDA multiple, grab a free copy of this recent Motley Fool special report.
At the time thisarticle was published The Motley Fool owns shares of Cisco Systems. Motley Fool newsletter services have recommended buying shares of Chevron and Intel. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.Fool contributor Matt Koppenheffer owns shares of Chevron and Intel, but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.
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