Several fund managers use multiple analysis to make apples-to-apples comparisons of various stocks. Using the secret formula that will be described below you can screen stocks that have performed well recently and have strong growth potential. The formula is as follows:
RANK = (EV/EBITDA*.4) + (ROE*.6)
The number that is generated (rank) will be used in order to the screen industry specific stocks. Using MS Excel this can be easily accomplished by using the sort function.
So you may be asking why use these multiples?
EV/EBITDA establishes whether the stock is a value or growth play. A high EV/EBITDA ratio describes a growth company.
The Enterprise Value/Earnings before Interest Taxes Depreciation and Amortization is a valuation ratio that unaffected by the company’s capital structure. This allows companies with totally different business models to be compared by value, free of debt, to earnings before interest. The nice thing about this strategy is that the multiple values don’t have to be calculated and can easily be extracted from certain websites. I use Google Finance to obtain EV/EBITDA ratios which also gives comparable company’s multiple ratios as well.
Enterprise Value can be calculated as market cap (common shares outstanding * stock price) plus debt, minority interest and preferred shares, minus total cash and cash equivalents.
There is much debate between money managers and academics over investing in growth vs. value companies. Generally speaking, money managers like growth and academics are into value. It is easier for an asset manager to ‘push’ flashy growth stocks like Apple and Baidu (Trading at 90x earnings) and much harder to convince people to buy a boring company like Lowes. The reality is that like the stock market, the performance of growth and value stocks fluctuate. Growth stocks enjoyed great success during the technology boom in the 1990s and from 2000-2004. However, as mentioned earlier trends change. We should be most concerned with more recent data.
In the Journal of Financial Analyst, Vol. 60, No. 1 (Jan. – Feb. 2004) there is a interesting article by Chan and Lakonishok that summarizes many of the great titian’s ideologies regarding the great debate of value vs. growth investing. Many academics such as Fama and French attribute the increased performance of value stocks to the level of risk that one undertakes when owning the stock.
I have compiled some data to observe the recent performance of growth vs. value stocks. It is hard to track, much less decipher whether a company is a growth and value play, so it is wise to use an index to extract this information. I use the ETFs iShares S&P Value Index (IVE) and iShares Growth Index (IVW). The results can be viewed below
iShares S&P Value Index (IVE)
3 month return: -5.6%
1 year return: 9.0%
iShares Growth Index (IVW)
3 month return: -4.1%
1 year return: 13.1%
From the data above it can be said that Growth companies have performed better in the recent past. Thus, a higher EV/EBITDA ratio will help us screen for growth companies when we rank stocks.
ROE - Return on Equity is basically a measure to determine how successful a firm has been at generating a return on common stockholders’ investment. ROE is return on common equity after accounting for the cost of debt financing and preferred stock dividends.
ROE = (Net Income – Preferred Stock Dividends)/ Average Common Stock Equity
Alternatively,
ROE = Operating ROA + Spread * Net Financial Leverage.
Again, you can find out a firm’s ROE using several finance websites. From this information above we can obviously determine that we would like to screen for companies with high ROE’s.
So you may also be asking why this ratio?
I do not have an exact answer for the aforementioned question but, after implementing this strategy for years the ratio has enjoyed much success. Feel free to manipulate this formula and do some back testing to find a ratio that works best for you. I feel that ROE is a more vital attribute to investors seeking companies to add to their portfolio. Thus, I weight ROE 60% and EV/EBITDA 40%.
How do I use this Secret Formula to screen stocks for my portfolio?
Now that you have a general understanding of how this formula is used. I will provide an example to hopefully clarify any questions that you may have at this point. I strongly urge you to implement this formula on an industry specific basis, due largely to the fact that certain industries are notorious for higher or lower EV/EBITDA and ROE ratios.
Example:
EV/EBITDA ROE Rank
C 20.2 12.30% 8.1538
B 14.9 20.10% 6.0806
A 13.7 10.50% 5.543
F 13.7 9.90% 5.5394
G 10.4 2.10% 4.1726
D 8.5 4.70% 3.4282
E 6.9 8.90% 2.8134
Above a made up scenario of example stocks labeled A through G are presented. Each has specific EV/EBITDA and ROE values. Using the Secret Formula to screen for high growth companies that are profitable for investors to hold in his/her own portfolio, it reveals that stock C is the winner. This process can be completed with ease using the Sort & Filter tab in MS Excel.
This model should be updated as you feel necessary. I personally update this model every 3-6 months. One of the great attributes about this strategy is that it is a relatively passive investment approach. Meaning, that you should not fret if you have not checked your portfolio in a few days.
Secret Formula
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