The P/E Ratio Might Not Be the Best Way to Value These 3 Super-Cheap Dow Stocks

Smoothing out erratic earnings and accounting for a company's balance sheet can help to discover which stocks are really cheap, and which are only pretending to be.

May 30, 2014 at 4:31PM

Everyone wants to find a great stock that's trading at a bargain price. Some investors will spend hours poring through data on hundreds of companies to find one standout stock to anchor a portfolio. But it might be far easier than you think to find your next great investment -- especially if you start with the 30 stocks that make up the Dow Jones Industrial Average (DJINDICES:^DJI).

These 30 companies generally exemplify the qualities we look for in great long-term investments: They're established market leaders with sustainable dividends that have put together decades of strong growth in all sorts of economic environments. However, investing isn't simply about finding a stock with great past performance. We also want to find a stock that's cheaply valued relative to its peers, as these lower-priced stocks might offer superior growth, as long as their financial performance can convince the market that it's been pricing them too cheaply all along.

We could start with the trusty P/E ratio, or even go further and compare a stock's current P/E to its 10-year average P/E (which I recently wrote about -- you can click here to see which Dow stocks topped that ranking). Today, however, we'll be looking at the enterprise value to earnings before interest, taxes, depreciation, and amortization ratio, or the EV/EBITDA ratio, to assess the Dow's components on a level playing field, where debt is added to a company's valuation, but cash is subtracted, and where earnings are smoothed out by using pre-tax and pre-interest figures that haven't been reduced by non-business accounting expenses.

It may not surprise you much to discover that three of the Dow's lowest-P/E components -- AT&T (NYSE:T), Travelers (NYSE:TRV), and Verizon (NYSE:VZ) -- top our EV/EBITDA rankings; but you might also be surprised to find out that some higher-P/E stocks rank quite well on our list. Let's look at the three best EV/EBITDA stocks now, and you'll find a full table of all 30 Dow components, ranked from lowest to highest EV/EBITDA ratio at the end of this article.

Third-cheapest EV/EBITDA on the Dow: Verizon (6.15)
Verizon's 6.15 EV/EBITDA is not only one of the lowest of all Dow components, it's also far more consistent than the telecom's wildly variable P/E, including the normalized P/E that excludes one-time costs:

VZ PE Ratio (TTM) Chart

VZ P/E Ratio (TTM) data by YCharts.

This is due, in large part, to the fact that Verizon's EBITDA has been far less volatile than its net income during the past few years, moving in a generally modest straight line upwards. Verizon's enterprise value has likewise moved higher at a much slower pace than its market cap. Both its EV and its EBITDA have increased by nearly the same amount, which has kept EV/EBITDA at rock-bottom levels for years:

VZ Net Income (TTM) Chart

VZ Net Income (TTM) data by YCharts.

Second-cheapest EV/EBITDA on the Dow: Travelers (5.32)
Insurer Travelers closes in on the top spot with a microscopic EV/EBITDA ratio that's been built on the second half of the ratio's equation -- there's really not that much of a difference between Travelers' market cap and its enterprise value.

TRV PE Ratio (TTM) Chart

TRV P/E Ratio (TTM) data by YCharts.

TRV Net Income (TTM) Chart

TRV Net Income (TTM) data by YCharts.

This isn't so unusual when you realize that many other insurers are in a similar boat. Many other major insurers boast an EV/EBITDA ratio that's roughly half their P/E, because insurance companies can make heavy use of amortization and other delayed expenses to smooth out their earnings over time. Travelers' depreciation and amortization alone takes out nearly a billion dollars from its operating earnings, and taxes sap a billion dollars, as well:

TRV Total Depreciation and Amortization (TTM) Chart

TRV Total Depreciation and Amortization (TTM) data by YCharts.

Cheapest EV/EBITDA on the Dow: AT&T (5.29)
AT&T barely edges Travelers for the lead in our EV/EBITDA rankings, but it does so with a ratio that's near its lowest level since the 1990s:

T PE Ratio (TTM) Chart

T P/E Ratio (TTM) data by YCharts.

As it has with Verizon, EBITDA presents a much smoother picture of AT&T's earnings than net income, which has bounced around quite a bit due to one-time charges over the years. However, before diving into AT&T shares, it's worth considering the fact that its EBITDA has only grown by 20% during the past five years, which is a rather weak gauge of post-recession progress when compared to many of its fellow Dow components' soaring bottom lines.

T Net Income (TTM) Chart

T Net Income (TTM) data by YCharts.

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Dowev Ebitda

Alex Planes owns shares of Intel. The Motley Fool recommends 3M, American Express, Chevron, Cisco Systems, Coca-Cola, Goldman Sachs, Home Depot, Intel, Johnson & Johnson, McDonald's, Nike, Procter & Gamble, UnitedHealth Group, Visa, and Walt Disney. The Motley Fool owns shares of General Electric Company, Intel, International Business Machines, Johnson & Johnson, JPMorgan Chase, Microsoft, Nike, Visa, and Walt Disney and has the following options: long January 2016 $37 calls on Coca-Cola and short January 2016 $37 puts on Coca-Cola. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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