5 Cheap Blue Chips You Can Buy Today

Published in Investing on 25 June 2012

History's best valuation measure suggests Rio Tinto (RIO) and BP (BP) look cheap.

We all have our favourite company valuation measures. Among the most popular you'll encounter are the price-to-earnings ratio (P/E), price-to-book value (P/B) 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 US stock data between 1971 and 2010. They found that while value-investor favourites low P/E and low P/B did indeed deliver similar average annual performances -- 15.2% and 15.0%, 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 Amortisation).

Unlike the P/E, where the ‘P' is derived simply from the company's market capitalisation, 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 chicanery 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 small ‘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 such as me uses!

I manually searched the FTSE 100 index (UKX) 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

CompanyShare priceEV/EBITDAP/E
Rio Tinto (LSE: RIO)2,982p2.95.8
Eurasian Natural Resources (LSE: ENRC)414p3.34.2
Kazakhmys (LSE: KAZ)702p3.94.1

Oil & Gas

CompanyShare price (p)EV/EBITDAP/E
BP (LSE: BP)407p3.15.1
Royal Dutch Shell (LSE: RDSB)2,174p3.57.4
BG (LSE: BG)1,218p7.113.2

Pharmaceuticals

CompanyShare priceEV/EBITDAP/E
AstraZeneca (LSE: AZN)2,772p3.85.9
GlaxoSmithKline (LSE: GSK)1,477p8.714.6
Shire (LSE: SHP)1,966p13.219.4

Aerospace & Defence

CompanyShare priceEV/EBITDAP/E
BAE Systems (LSE: BA)287p4.36.9
Meggitt (LSE: MGGT)371p8.714.2
Rolls-Royce (LSE: RR)843p9.919.1

Supermarkets

CompanyShare priceEV/EBITDAP/E
J Sainsbury (LSE: SBRY)294p5.810.9
Wm Morrison (LSE: MRW)270p6.110.3
Tesco (LSE: TSCO)312p6.59.6

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 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.

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G A Chester does not own shares in any of the companies mentioned in this article. The Motley Fool owns shares in Tesco.

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Comments

The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

goodlifer 25 Jun 2012 , 8:06pm

About EBITDA Warren Buffett says -among other things -

"References to EBITDA make us shudder — does management think the tooth fairy pays for capital expenditures? We're very suspicious of accounting methodology that is vague or unclear, since too often that means management wishes to hide something."

Do Gray and Vogel really know better?

Having said that I agree that the shares you mention are probably all worth buying for obvious, basic reasons.

Netherwood 27 Jun 2012 , 12:38pm

Lets have a look at these so called bargains in a year or so when their earnings have been trashed. PE's based on Historically high earnings are to be viewed with caution

Fabius1 27 Jun 2012 , 12:51pm

Goodie

Absolutely. Cash only please.

charvil 27 Jun 2012 , 3:18pm

The cheap ones are the worst performers IMHO

TotSPetruchio 27 Jun 2012 , 10:18pm

Shares become cheap in reality?
Is not BP hungover from Macondo ,accident prone and other gas issues TNK/BP?
And as far as i can see Iron Ore prices will be low for the next two years until demand exceeds the capacity of Australia to supply?When my "digger" mates in AUS are investing to upset the fragile ecologies?
It has to be dare to win.
Maybe tomorrow morning!

15551 05 Jul 2012 , 12:11pm

I'm arriving at very different figures, not sure why

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