How to Find 'Cheap' Stocks With the Enterprise Value-to-EBITDA Ratio

This column was written by RealMoney contributor Tim Melvin. For more information about subscribing to RealMoney, please click here.

One of the most important keys to long term success in the markets is the willingness to embrace new ideas. As a deep value investor, one of the hardest things to do is find new stocks that are cheap, have a margin of safety and are not value traps that linger for years with no real price improvement.

Often, companies are cheap for a fundamental reason and have no real prospects for improvement. One imagines that the last buggy whip manufacturers sold at very low multiples of earnings and book value after the introduction of the Model T.

I have always had a deep distrust of using ratios based on reported earnings as it is just too easy -- under accounting rules -- to cloud the income statement and give a less than accurate view of earnings. As a result, I have been an asset -based investor most of my career, as I find balance sheets easier to rip apart than the income account. In recent years, however I have used another measure to look for undervalued stocks.

The EV/EBITDA Ratio

The enterprise value-to-EBITDA (EV/EBITDA) ratio has helped me uncover stocks that were very cheap based on underlying business value, and as a bonus it is one of the measures used by private equity funds to find attractive takeover candidates.

There are two elements to the ratio. First of course is enterprise value. This is simply the equity of the common stock at market prices, plus outstanding debt and preferred equity. From this number we subtract the cash and equivalents the company carries on the books. This number represents the market value of the business.

The next measure is EBITDA . This number represents the company's earnings before interest, taxes, depreciation and amortization. It gives us a solid idea of how much cash came in the door after the costs of running the business. It eliminates non-cash charges and financing expense to allow a better picture of the earnings power of the underlying business.

Measuring the EV/EBITDA ratio gives some idea of how long it would take the earnings to pay off the price of buying the entire business, including the assumption of debt. For instance, if you were to buy an entire company for its enterprise value of $100 million (after adding in all debt and subtracting cash), and they had EBITDA of $25 million annually, you would be have your purchase price back in the form of cash in the till in just four years.

In one of my favorite academic studies by the Brandes Institute, entitled "Falling Knives," the EV/EBITDA measure along with the ability to avoid bankruptcy (see "How to Find Value Stocks With the Z-Score and Piotroski Scale"), was responsible for much of the outperformance from stocks that had fallen steeply in price over the preceding 12 months.

Behind the Screens

This measure has become one of the screens I run every week to scour the dark corners of the stock market for names that are cheap enough to buy and have a likely catalyst to cause prices to begin to recover. I also add a debt filter, as I am a huge believer in the concept of margin of safety as explained by Ben Graham and the cornerstone of the investment techniques of legendary value investors such as Seth Klarman and Tweedy, Browne Company. I use a maximum debt-to-equity level of 50% and an enterprise value-to-EBITDA ratio of 5 or less. This is the level that appears to attract interest from both financial buyers of companies, such as private equity funds, as well as strategic buyers looking to grow through acquisition .