Last Updated on 3 July 2021 by F.R.Costa

Finding cheap stocks is no easy task because it’s rather difficult to know what the fundamental, or intrinsic price of a stock is. Some will say Tesla is going to the moon from its current $680 price tag, others would argue that the current price is already discounting a hefty growth rate and the only way to go from here is down. It’s difficult to predict growth rates for a stock and even if such predictions were right, there’s always an unpredictable fraction of the price, which comes from sentiment. A stock may remain expensive or cheap for longer than our wallet can take.

Because cheapness (or value) is a relative notion and a stock may remain out of sync with its fundamentals for long, we need to measure value in relative terms and select a portfolio of value stocks instead of just one. The best is to find good proxies for value, apply them to a group of stocks and then select a few on the top positions.

Recalling the Tesla example, the stock reported an EPS of around $1. If we apply the P/E ratio, we get a figure of around 680x. Again, much could be said about these figures, as they are a picture of the past. If Tesla grows as expected, its EPS for 2021 would be around $4.5 and its forward P/E around 151x. And if we continue digging into the future, given the current growth expectations, the number would look even more normal. However, these are just expectations and are more likely to be revised down than up, as they’re already positively skewed. Paying this much for future profits places an investor in an uncomfortable position in terms of downside risk.

Four ratios to deal with cheapness

Price ratios tell us how much we’re paying for assets, sales or profits if we buy one share. Unfortunately, valuations using share prices can be distorted by the way a company is financed and give misleading signals regarding the cheapness of a company’s stock. A simple example helps understand it. If a company decides to repurchase shares, its P/E ratio would appear improved, even though the total profits are the same. However, if we alternatively use enterprise value instead of the stock price in our ratio, this wouldn’t happen. Any change in the way a company is financed will lead to changes in ratios using share prices. Thus, following in the footsteps of Phil Oakley, I prefer to use Enterprise Value (EV) in my valuations. EV corresponds to the amount a buyer would have to pay to buy a company as a whole, not just the equity part of it. It includes the market value of equity, total borrowings, preferred equity, pension fund deficit, minority interests and excludes cash and cash equivalents.

With the above in mind, we may try to figure out how much value is being generated by a company’s:

  1. Assets
  2. Sales
  3. Cash Flows
  4. Profits

Or, in a different way, we can try to figure out how much we’re paying for assets, sales, cash flows and profits if we were to buy the company. While there are many different ratios to help us value a business, I’m going to look into the following four:

  • Enterprise value to capital employed (EV/CE) – Because we’re centred around the total value of an enterprise instead of per share values, we are replacing the well know P/NAV of P/B for EV/CE, which stands for enterprise value to capital employed. This ratio gives an idea on how much we’re paying for the total capital employed (or money invested) in the business. We want this ratio to be as low as possible but the value of the business as an ongoing concern is generally higher than the money invested on it.
  • Enterprise value to turnover (EV/Turnover) – Before making money, a company must sell something, be it cars, hotel rooms or ad space on its website. Thus nothing better than starting with the top line before going down to profits. Tesla, for example, had no profits until 2020. Any ratio based on profits would not tell anything meaningful. However, it had sales, which could be measured. The ratio EV/Turnover is similar to P/Turnover (or P/S). The lower the number, the better.
  • Enterprise value to EBIT (EV/EBIT) – We want to know how much we’re paying for the profits of the company. Since we’re using EV instead of share price, we must use some measure of profits that reflects the profits available to all stakeholders of the company, which is the case with EBIT. EBIT stands for earnings before interest and taxes and is a measure of operating profits. It is a clean measure of profits that tells us how much a company is making after discount all expenses but before paying taxes (which vary with jurisdiction) and interest (which vary with leverage). The lower the ratio the better, as we would be paying less for the profits of the company. Some investors like to work with EBIT/EV instead, which is known as EBIT yield. The interpretation is similar but inverted.
  • Enterprise value to free cash flow to the firm (EV/FCFf) – Because profits not always translate into cash being available, we may also valuate the cheapness of the company by looking at the free cash flow available to the firm. Free cash flow for the firm (FCFf) measures the amount of surplus cash flow left over to pay lenders and shareholders after assets have been replaced, new assets have been invested to grow the business (CAPEX) and tax has been paid.

A stock screener and a ratings system

After establishing our proxies for cheapness (or value), what we need is a stock screener. A good one is provided by Sharescope and sharepad. Some investors like to set a maximum value for each of the ratios and to select the stocks surviving it. They then define some criteria for the final selection, which can involve market capitalisation, price movement, or something else. But, depending on market state, a good number today may not be good tomorrow. Instead of trying to guess what is a good figure for cheapness in absolute terms, we may do this in relative terms. Thus, we don’t set any maximum value but attribute ratings to each stock, depending on the ratio level. If you have a list of 100 stocks, you give a rating of 100 to the highest ranking stock in your list and a rating of 1 to the lowest ranking stock. You can do this for the four ratios above and sum the ratings for each stock to get a final number. The best rated stock is your first selection, the second best is your second selection and so on, until reaching the exact number of stocks you want to buy. The advantage of this procedure is that you’re looking at cheapness (value) in relative terms. It doesn’t matter whether a EV/EBIT of 20x is high or low in absolute terms but how it ranks in a list of many stocks. At building a composite rating that includes more than one ratio, you’re establishing a good way of ranking stocks.

From this procedure, we could develop several alternatives. Let me give a few examples. We could attribute different weightings to each rating, if we feel some ratio is more important than other. After selecting the desired number of stocks, we may equal-weight them or value-weight them according to their respective market caps. There are many, many options. What matters the most is that, we have a good strategy. So, let’s use it!

About F.R.Costa

Filipe has more than 20 years experience with financial markets. He holds a degree in Economics with a specialisation in Finance and he's currently finishing a PhD in Finance. He used to work as financial consultant and research associate but then decided to return to academia five years ago. Since that, he has been an Invited Lecturer, teaching courses on Investments, Financial Markets, and Monetary Economics. He is also a regular contributor writer at The Master Investor Magazine.

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