More from this Author
- January 23, 2012
- October 31, 2011
- October 26, 2011
- September 28, 2011
What works best to make money in stocks?
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.” I’ll explain what it is in a minute.
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.
To double-check these results, I looked at the fantastic book by James O’Shaughnessy, What Works on Wall Street.
O’Shaughnessy ran his numbers from 1964 to 2009. He found that buying the cheapest 10% of stocks based on EV/EBITDA returned 16.58% a year. According to O’Shaughnessy, $10,000 invested in buy-and-hold from 1964 to 2009 turned into $1.3 million. But investing based on EV/EBITDA turned $10,000 into $11.6 million!
Let me show you how the EV/EBITDA ratio compares to the old classic, the P/E ratio…
“EV” means enterprise value. It’s essentially the “P” from the classic P/E ratio, plus debt. In my view, it’s more correct to take debt into account, and the P/E ratio doesn’t do that.
“EBITDA” compares to “E” in a similar way… “E” is classic earnings. “EBITDA” is more like the actual cash flow from the business, before the accountants can mess with it.
Two good sources show that buying stocks with cheap EV/EBITDA ratios relative to the market is an incredibly profitable strategy. So what can we do with this knowledge today?
I ran a screen of S&P 500 companies based on EV/EBITDA…
Sitting near the top was the company Steve Sjuggerud recently described as the “Master of the Universe” in copper… Freeport-McMoRan (FCX).
Right now, Freeport trades at an EV/EBITDA of just 2.5… That’s dirt-cheap. And according to Bloomberg, it’s the cheapest the stock has ever been.
The news gets better. During the second half of 2011, Freeport shares were crushed. But now, the stock is breaking out. Check it out…
As Steve explained, Freeport-McMoRan is the biggest player in the world’s copper market. And it will trade with the price of copper. But the trend is up in copper as well.
That’s why our opportunity is so good. For the first time in six months, Freeport shares AND copper are trending higher. That gives us a low-risk opportunity to buy. With an EV/EBITDA of just 2.5, it’s hard to imagine Freeport getting any cheaper. And, as Steve explained, the upside is hundreds of percent.
If you’re looking for a proven valuation indicator, EV-to-EBITDA has proven to be the best over the last 40 years. And if you’re looking for a cheap stock based on this proven measure, look no farther than Freeport…
– Brett EversoleSource: Daily Wealth
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