What is the best valuation metric used to identify stocks trading at a discount to intrinsic value? The most popular metric is the price to earnings (P/E) ratio. Others may argue that price to book or price to cash flow is the best valuation metric. The proven answer is the enterprise value to EBITDA (EV/EBITDA) metric. Enterprise value is the price plus debt while EBITDA is the earnings before interest, taxes, depreciation and amortization. Recent research has found the EV/EBITDA to be the most effective method to getting better returns.
Wesley Grey and John Vogel of Drexel University recently took this topic head-on, and came up with some interesting results. Grey and Vogel published a paper called "Analyzing Valuation Measures: A Performance Horse-Race over the past 40 Years." From the start, their objective was simple… "Our basic research question: Which valuation metric has historically performed the best?"
Based on Grey and Vogel's research, the best valuation measure wasn't the classic price-to-earnings (P/E) ratio. It's something similar to the P/E ratio though, with a more intimidating name: "EV-to-EBITDA."
Grey and Vogel found that buying the cheapest 25% of stocks based on EV/EBITDA returned 17.66% a year from 1971-2010. This beat buying cheap stocks based on the P/E ratio, which returned just 15.23% a year over the same time.
My idea is to apply the EV/EBITDA metric to dividend stocks. It makes sense to buy dividend stocks at a lower value which gives the investor higher dividend rate of pay while waiting for a stock price increase to a higher valuation. I am looking at stocks with a dividend yield of at least 3% and a return on equity of at least 10%. The table below shows the best stocks meeting the criteria along with their EV/EBITDA ratios.
The list is loaded with companies in the oil industry with EV/EBITDA ratios below 5.0 such as: StatOil (STO), Marathon Oil (MRO), Total (TOT), ConocoPhillips (COP), and Chevron (CVX). Among this group, TOT has the highest dividend yield at 5.0% with an EV/EBITDA of 3.23.
The telecom industry is well represented by companies such as Telecom Argentina (TEO), China Mobile (CHL), P.T. Telekomunikasi Indonesia, (TLK), BT Group plc (BT) and Telefonos de Mexico SA de CV Co (TMX). TLK has a 7.2% dividend yield with an EV/EBITDA of 4.01.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.