5 Cheap Blue Chips You Can Buy Today

LONDON -- We all have our favorite company valuation measures. Among the most popular you'll encounter are the price-to-earnings ratioprice-to-book value, and dividend yield.

But which measure is best? According to distinguished finance professors Eugene Fama and Ken French: "One fundamental (book value, earnings, or cashflow) is pretty much as good as another … and the average return spreads produced by different ratios are similar to and, in statistical terms, indistinguishable from one another."

This orthodoxy has recently been challenged in a paper from Drexel University's Wesley Gray and Jack Vogel: "Analyzing Valuation Measures: A Performance Horse-Race Over the Past 40 Years." Gray and Vogel examined U.S. stock data between 1971 and 2010. They found that while low P/E and low P/B -- two favorites among value investors -- did indeed deliver similar average annual performances (15.2% and 15%, respectively), a less popular measure delivered a significantly higher average annual return of 17.7%.

In passing, it's worth mentioning that the worst-performing metric by a mile was forecast P/E -- "suggesting that investors shy away from using analyst earnings estimates to make investment decisions."

Top ratio
Gray and Vogel found the best indicator of superior future returns to be a low EV/EBITDA -- enterprise value divided by earnings before interest, tax, depreciation, and amortization.

Unlike the P/E, where the "P" is derived simply from the company's market capitalization, EV also takes account of debt. EV can be calculated as market cap plus net debt (or minus net cash). EV puts companies with different levels of debt and cash on a level playing field. EBITDA does a similar thing on the earnings side -- but is scorned by many private investors, for whom it will always be associated with dot-com era accounting trickery that made unprofitable companies look profitable.

All financial ratios have their strengths and weaknesses, but Gray and Vogel's work suggests we would be foolish (with a lowercase "F") to ignore EV/EBITDA's strength as the best single measure of a company's "cheapness."

Cheap as (blue) chips
EBITDA isn't a required entry on company income statements, so it tends not to be among the criteria you can screen for using online stock screeners -- or the free ones a skinflint like me uses! So I manually searched the FTSE 100 index for five cheap EV/EBITDA shares in five different industries, using Morningstar, whose independent analysts calculate EBITDA.

I followed Gray and Vogel by excluding financials and utilities, because EV doesn't work for financials, while the economic returns of utilities are set by regulators. Each of the five tables below is headed by a cheap EV/EBITDA share, followed by its two FTSE peers (or the next cheapest two, where there are more than three companies in the sector).

Miners

Company

Share Price (pence)

EV/EBITDA

P/E

Rio Tinto  (LSE: RIO.L  ) 2,982 2.9 5.8
Eurasian Natural Resources 414 3.3 4.2
Kazakhmys 702 3.9 4.1

Oil and Gas

Company

Share Price (pence)

EV/EBITDA

P/E

BP  (LSE: BP.L  ) 407 3.1 5.1
Royal Dutch Shell 2,174 3.5 7.4
BG 1,218 7.1 13.2

Pharmaceuticals

Company

Share Price (pence)

EV/EBITDA

P/E

AstraZeneca  (LSE: AZN.L  ) 2,772 3.8 5.9
GlaxoSmithKline 1,477 8.7 14.6
Shire 1,966 13.2 19.4

Aerospace and Defense

Company

Share Price (pence)

EV/EBITDA

P/E

BAE Systems  (LSE: BA.L  ) 287 4.3 6.9
Meggitt 371 8.7 14.2
Rolls-Royce 843 9.9 19.1

Supermarkets

Company

Share Price (pence)

EV/EBITDA

P/E

J Sainsbury  (LSE: SBRY.L  ) 294 5.8 10.9
Wm. Morrison 270 6.1 10.3
Tesco 312 6.5 9.6

As you can see, BP, AstraZeneca, and BAE Systems are all cheap on both EV/EBITDA and P/E, and the peer companies in their sectors are ranked identically on both measures.

In the case of miners and supermarkets, though, the EV/EBITDA ranking runs opposite to the P/E ranking. Rio Tinto is more expensive than Eurasian Natural Resources and Kazakhmys on P/E, but it's the cheapest of the three on EV/EBITDA. Likewise, Sainsbury is a pricier P/E share than Morrison and Tesco but comes out cheapest at the EV/EBITDA checkout.

Let me wrap up by adding that, if you're interested in building wealth from blue-chip shares, then you must download a copy of "8 Shares Held By Britain's Super Investor," The Motley Fool's latest report for intelligent investors. The guide reviews the investing approach and portfolio of City dividend legend Neil Woodford and is free to download today.

David Kuo challenged his Motley Fool analysts to pinpoint the attractive sectors of 2012 -- and they delivered! Discover the industries they selected in this new Motley Fool guide -- “Top Sectors for 2012” -- while it's still free!

Further Motley Fool investment opportunities:

G A Chester does not own shares in any of the companies mentioned in this article. The Motley Fool owns shares of Tesco. Motley Fool newsletter services have recommended buying shares of Tesco. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


Read/Post Comments (0) | Recommend This Article (1)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1923249, ~/Articles/ArticleHandler.aspx, 10/24/2014 6:38:16 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement