Using Enterprise Value to Locate Bargains

The First Cut is designed as a starting point for investors. Each issue we list the top 30 stocks that pass relatively simple screens of interest to individual stock pickers. AAII’s Stock Investor Pro screening software is used to generate the First Cut listing.

While market capitalization (stock price times number of outstanding shares) reflects the overall trading value of a company, it does not fully capture the cost of acquiring a firm. Instead, investors turn to the “enterprise value” to help measure the overall outlay of buying out a company. The enterprise value is calculated by adding market capitalization, preferred stock, and total debt and reducing this total by the amount of cash held by the firm. Debt and preferred stock is added because the acquirer must shoulder the cost of assuming the obligations of the firm. Cash is subtracted because once you acquire the firm, it becomes yours.

To gauge the worth of a company, the enterprise value is normally related to earnings before interest, taxes, depreciation and amortization (EBITDA). EBITDA ignores non-cash expenses such as depreciation of already paid for fixed assets and amortization of intangibles because they do not impact pretax cash flow. EBITDA ignores taxes and interest payments, which will likely change after an acquisition or merger. The enterprise value to EBITDA ratio relates a firm’s takeover cost to its earnings potential. The lower the ratio, the more attractive the firm.

The stocks that made this issue’s First Cut are domestic, exchange-listed stocks with a minimum share price of $5.00. Financials were excluded because their unique financial structure cannot be directly compared to firms in other industries. As a test for minimum financial strength, stocks were required to have a debt-to-equity level below 50% as well as positive free cash flow. The 30 stocks with the lowest enterprise value to EBITDA made the First Cut. The historical growth rates in the table help to bring to light past top and bottom-line company performance. The 52-week price change highlights the weak stock price performance of most of these stocks. Value screens such as this often turn up out-of-favor companies and industries. Keep in mind that all screens are starting points; the goal of the EV/EBITDA screen is to create a list of attractively priced stocks.

Using the Ratio of Enterprise Value to EBITDA to Locate Bargains