Using EV / EBITDA To Enhance Dividend Stock Selection

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 |  Includes: COP, CVX, INTC, MSFT, NOC, VZ
by: Richard Shaw

Dividend investing is a form of value investing if done with care. Chasing yields without considering value is a speculative approach, likely to become a disappointment.

There are many ways to test for value. One we like is EV/EBITDA, which represents the cost of purchasing the entirety of a company with cash, unencumbered by any debt - a valuation measure used widely in analysis of private equity takeovers. It effectively puts all companies on a common capital structure - all common equity with no debt. That is similar to "common size" analysis in financial statements.

EV = Common Stock Market Capitalization + Preferred Stock + Total Debt - Short-Term Investments - Cash

EBITDA = Net Earnings + Interest Expense + Taxes + Depreciation and Amortization

Some Supporting EV/EBITDA Research:

There are a number of reasonably effective valuation measures, but we are partial to EV/EBITDA, because it unravels the capital structure to reveal the full cost of the fully unlevered company.

Some recent research has shown EV/EBITDA to be somewhat more effective at identifying value than other methods such as P/E, P/B and EV/FCF.

research source:
"Analyzing Valuation Measures: A Performance Horse-Race Over the Past 40 Years," by Wesley R. Gray and Jack Vogel, Drexel University, March 29, 2012, Journal of Portfolio Management

Here is a summary of some of the findings. The stocks were tested for the effectiveness of valuation by quintiles over a 40 year period, based on both equal weighting and market-weighting. We applied color coding horizontally to show which valuation method worked best per quintile. EV/EBITDA worked best for the "cheapest" two quintiles.

Figure 1:

(click to enlarge)Click to enlarge

We don't want to dwell on the valuation method choice, but wanted to give some third party support to appreciation of the method. You can read the study if you want more details about the research.

Their data was based on the entire universe of stocks with 40 years of data, minus financials, utilities, CEFs, and the 10% lowest market caps stocks (and, of course, minus ETFs which have not been around for 40 years). Our data that follows is based on the S&P 500 yielding stocks.

Relationship Between Valuation and Yield:

We did not find any demonstrable relationship between current EV/EBITDA and yield or the 5-year growth rate of dividends. However, that is not all bad news. Since yields of all sorts can be found across the valuation spectrum, why not chose stocks with attractive yield and dividend growth characteristics at the same time?

This scatter diagram is of EV/EBITDA vs yield and the other of EV/EBITDA vs 5-year dividend growth rate show that lack of relationship.

We excluded the extreme valuations and yields and growth rates to allow the charts to more effectively show the dispersion.

Figure 2:

Figure 3:

Current EV/EBITDA Deciles:

If selecting dividend stocks for attractive valuation is useful, then what is the current valuation by deciles for all profitable companies in the S&P 500?

Based on the academic research discussed above, the four deciles (equals two quintiles) with the lowest EV/EBITDA are probably a better place to look for dividend values than in the other six deciles.

The stocks in Figures 4 are for S&P 500 stocks with a current yield and at least a 5-year history of dividend payments, and a currently positive EBITDA.

The best 4 deciles of valuation range from a high of 9.83 to a low of 2.65, with medians of 4.58, 6.90, 8.37 and 9.46. Financials are excluded, which is the convention.

Notation: The research paper numbers "expensive" to "cheap" 1-5. We numbered "expensive" to "cheap" 10-1.

Figure 4:

EV/EBITDA
Decile High Low Median Average
1 Best 6.09 2.65 4.89 4.58
2 7.77 6.28 6.78 6.90
3 8.95 7.78 8.43 8.37
4 9.83 8.97 9.49 9.46
5 10.72 9.95 10.33 10.31
6 11.79 10.72 11.20 11.20
7 13.17 11.82 12.63 12.56
8 14.93 13.23 14.15 14.11
9 18.06 15.29 16.31 16.52
10 Worst 79.82 18.19 23.66 32.62
Click to enlarge

Figure 5:

For comparison, this table includes all non-financial stocks in the S&P 500, without the yield and dividend growth criteria used for inclusion in Figure 4. There is very little difference between the ranges, medians and averages for the two universes in the cheapest 4 deciles.

EV/EBITDA
Decile High Low Median Average
1 5.75 2.65 4.46 4.37
2 7.59 5.76 6.66 6.65
3 9.02 7.60 8.33 8.30
4 10.06 9.15 9.62 9.60
5 10.98 10.07 10.50 10.54
6 12.31 11.01 11.54 11.59
7 13.72 12.37 12.94 12.97
8 16.08 13.74 14.81 14.89
9 22.01 16.11 18.13 18.78
10 126.68 22.28 35.70 41.07
Click to enlarge

EV/EBITDA By Sector:

These data are based on the same stocks as for the deciles, except that financials are included in their own sector. Convention is that EV/EBITDA is not appropriate for financials, but we provide the data anyway in its own bucket.

These sector data should be generally more useful, because you can compare stocks to stocks that may be more similar than the index overall.

Figure 6:

EV/EBITDA
Sector High Low Median Average
Utilities 18.93 6.61 10.73 11.21
Transports 13.28 4.90 8.85 8.63
Tech 72.72 5.96 10.94 13.23
Services 40.66 3.11 10.91 12.62
Healthcare 29.23 6.78 10.58 12.55
Financials 192.37 2.13 9.00 14.37
Energy 21.39 2.65 6.28 7.23
Consumer Non-Cycl. 47.35 6.43 14.06 16.97
Consumer Cycl. 16.26 6.77 11.17 12.05
Captial Goods 51.82 5.18 8.77 13.45
Basic Materials 79.82 3.87 10.68 14.61
Click to enlarge

EV/EBITDA of Some of Our Dividend Holdings:

Here are 6 of our dividend stock holdings and their EV/EBITDA:

  • COP (Conoco) 2.65
  • CVX (Chevron) 2.99
  • NOC (Northrup Gruman) 5.18
  • VZ (Verizon) 5.76
  • MSFT (Microsoft) 6.96
  • INTC (Intel) 7.01

We hope this helps your DIY dividend investors a bit with valuation assessment.

There are, of course, many other factors to consider, and what is true statistically for a batch of stocks with a low EV/EBITDA is not necessarily the same for a single stock. Some individual stocks have low EV/EBITDA because they are failing.

Apple (NASDAQ:AAPL) and Research In Motion (RIMM) are two good examples.

The EV/EBITDA for AAPL is 8.7 (attractively lower than the 10.94 median for the tech sector, and not terribly higher than the 5.96 low). The same ratio for RIM is 0.91. That company is on its last legs, and 0.91 is not a sign of value.

The Growth Factor:

Sales growth, earnings growth and dividend growth, among others are important factors to compare stocks with similar EV/EBITDA. Faster growth for a given EV/EBITDA is preferable (but watch out for very high growth which may not be sustainable).

One very convenient way to include the growth factor is to check your best prospects against a GARP (growth at a reasonable price) index, such as the one for the Russell 1000. That can be helpful.

Let's say that moderate to low EV/EBITDA is a desirable, but not sufficient alone for a dividend stock buy decision.

Disclosure: QVM has positions in AAPL, COP, CVX, NOC, VZ, MSFT and INTC as of the creation date of this article (July 9, 2012).

General Disclaimer: This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. Do your own research or obtain suitable personal advice. You are responsible for your own investment decisions. This article is presented subject to our full disclaimer found on the QVM site available here.