By JACK HOUGH
Many investors use the price-to-earnings ratio to tell whether stocks are cheap. It shows how many dollars a buyer must pay for each $1 in yearly earnings the company produces. There are other such measures that show how much investors must pay for things like assets and free cash.
A pair of Drexel University professors, Wesley Gray and Jack Vogel, recently published the results of what they call a 40-year horse race among a handful of valuation measures. It shows how each performed as a predictor of stock returns between 1971 and 2010. The winner reads like the bottom line on an eye exam chart: EV/Ebitda.
EV stands for enterprise value. That's the cost to buy a company in full and pay off what it owes while pocketing its cash. Ebitda is earnings before interest, taxes, depreciation and amortization. It's meant to zero in on the core profitability of a company's operations.
Buyout firms use measures like EV/Ebitda in determining which takeover candidates are cheap, because they're concerned with the total price of companies (debt and all) and the earnings potential that can be unlocked later.
The study results suggest stock-pickers would do well to think like corporate raiders. The cheapest one-fifth of stocks ranked by P/E ratios returned 15.2% a year during the study period, versus 13.0% for an equal-weight portfolio of all the stocks. The one-fifth of stocks with the lowest EV/Ebitda ratios, however, returned 17.7% a year.
Adjusting the results for other factors that are linked with stock performance, like volatility and company size, confirmed the predictive power of low EV/Ebitda ratios.
A search for takeover targets, on the other hand, looks at more than just valuation, including cash flow, leverage, size and industry-specific factors. Morningstar on Wednesday published a list of its analysts' top 20 takeover candidates based on just such factors.
Among ones with low EV/Ebitda ratios and no net debt are teen clothier American Eagle Outfitters (AEO),