A Ratio to Evaluate Bargains

 | May 20, 2014 | 1:00 PM EDT
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As part of my regular reading and reviewing Monday, I came across an article form Tobias Carlisle, one of the authors of the excellent Quantitative Value book published last year.

In the article, Carlisle looks at the performance of value stocks since 2008 and found that when enterprise value to earnings before interest, taxes, depreciation and amortization (EBITDA), is used as the measure of value they have outperformed the market by a wide margin. The outperformance persists across all market caps. The stocks in the lowest decile of stocks ranked by EV/EBITDA blew away the overall stock market by an average of more than 7% a year.

This is pretty easy to screen for, so I fired up the computer this morning and looked for some stocks that trade in that bottom 10%. The cutoff point was right around 5 so I looked for stock with an EV/EBITDA ratio of 5 or lower. Interestingly that's the same EV/EBITDA level that many of my private equity friends tell me is their prime hunting ground for potential buyout candidates. Companies that trade at this level or lower are basically earning a 20% EBITDA yield on total capital invested in the enterprise minus cash balances so it makes sense that they could outperform the averages.

Green Dot Corporation (GDOT) is one company that makes the list and has an interesting business. They sell prepaid debit cards and debit card reloading services to the unbanked segment of society. As the world moves away from cash and online shopping is more of presence than ever before, consumers who do not use the services of normal banks need to have access opt payment mechanisms for the new plastic and electronic world and Green Dot fills this void.

The stock fell recently after Green Dot missed revenue expectations and issued guidance for the rest of the year that was a little lower than Wall Street was hoping to see. The company is now a bargain as measured by the EV/EBITDA Ratio of just 2.2.

Unisys (UIS) has fallen off most investors radar screen for years now but the IT services and technology solution provider is on our list of cheap stocks with market beating potential. Higher-than-expected pension expense contributed to the company earning less than expected in the first quarter and the stock has fallen sharply since then. Unisys is pretty well positioned in the cyber security and data center management sectors of the IT market and earnings should rebound over the next few years -- especially if corporate spending finally begins to increase. Right now the shares trade with an EV/EBITDA ratio of just 3.9.

As with every other list of cheap stocks you can think of right now gold miners make the list. Kinross Gold (KGC) has operation in the U.S., Canada, Russia, South America and Africa. Concerns about their large Russian operation have weighed on the stock due to tension over the situation involving Ukraine and the stock is now cheap based on both EV/EBITDA and book value. The shares are currently trading at just 76% of book value and have an EV/EBITDA ratio of just 3.6.

At some point the relationship with Russia will be fixed and gold may even rally again in the next few years and turn Kinross into a winning stock that handily beats the market.

The St. Joe Company (JOE) has seen its stock perk up a little bit after announcing earnings earlier this month but the stock is still cheap based on its 2.9 EV/EBITDA ratio. The company has sold substantial portions of land that didn't fit into their long term plans and now has over $500 million in cash on hand.

The stock has been a battleground for two noted investors as David Einhorn has been publicly short the stock while Bruce Berkwotiz has accumulated more than 25% of the company. Based on recent developments it looks like Berkowitz is going to win this particular argument.

Although price-to-book value will always be my go-to-metric for picking undervalued stocks, EV/EBITDA is an important ratio when evaluating potential bargain stocks. It is used by some value investors like Carlisle as well as many private equity and buyout investors to identify cheap stocks. It should be in the toolbox of all serious long-term investors.

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I reached out last week to my close friend Ken Shreve, who is a prominent writer for the IBD.  I asked Ke...
I reached out last week to my close friend Ken Shreve, who is a prominent writer for the IBD.  I asked Ke...
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