Throughout the second quarter, several gurus have added to their positions in retail companies. Two apparel & specialty companies, eBay Inc. (EBAY, Financial) and Gap Inc. (GPS, Financial), are currently undervalued based on valuation and enterprise value ratios. This suggests that the retail industry offers good short-term investing opportunities.
Valuation ratios and EV ratios: similar topics, albeit different perspectives
As discussed in the previous article, the price-earnings (P/E) ratio can give misleading information about a company’s fair value, especially in cyclical industries like airlines and retail. The price-sales (P/S) ratio or the Shiller P/E ratio generally give more useful valuations. Alternatively, investors can measure the fair value using enterprise value ratios, including EV/EBIT, EV/EBITDA and EV/Sales.
Unlike the valuation ratios, which are based on a company’s stock price, the enterprise value ratios are based on a company’s enterprise value. Unofficially known as the “theoretical takeover price,” the EV adds the company’s preferred stock, total debt and minority interest and then subtracts the company’s net cash. As the EV ratios consider the company’s debt, net cash and important nonoperating items like tax and interest, these ratios generally give more accurate valuations than the basic valuation ratios do.
The distribution of EV ratios among industries is mildly right skewed, and the median averages of EV/EBIT and EV/EBITDA are 16.49 and 11.51. EV/EBIT has the highest standard deviation among the three EV ratios while EV/Revenue has the lowest standard deviation.
Retail companies offer high growth potential at low valuations, gurus boost stakes
The “EV Retail Screener” lists the retail companies that have a trailing 12-month P/E ratio less than 14, an EV/EBIT ratio less than 20, an EV/EBITDA ratio less than 28 and a 10-year EBITDA growth rate greater than 5%. This strategy generated an overall return of 93.18% using annual rebalancing and a maximum of 10 stocks ranked by increasing P/E ratios during the backtesting period from 2006-2016. Thirteen companies, including Gap, met all of the above criteria as of Sept. 26.
Even though the company has modest interest coverage, the California-based retail company has strong Altman Z-scores and high returns on equity. This suggests that Gap still has high growth potential in the short term. Additionally, the company’s return on invested capital outperforms its WACC, suggesting that Gap creates value as it grows.
EBay has expanding operating margins and high Greenblatt return on capital, albeit negative three-year revenue and EBITDA growth.
Nine gurus, including Edward Lampert (Trades, Portfolio), Steven Cohen (Trades, Portfolio) and Ray Dalio (Trades, Portfolio), invested in Gap during the past three months. Lampert, who currently owns over 3.4 million Gap shares, increased his Gap position by 5.3% during the second quarter. Cohen and Dalio purchased 708,700 and 359,813 shares of Gap at an average price of $21.29 per share.
Eleven gurus invested in eBay during the second quarter, including First Eagle Investment and PRIMECAP Management (Trades, Portfolio). The former purchased 1,935,555 eBay shares at an average per-share price of $24.12 while the latter increased its position by 5.05%. With over 8.722 million shares, PRIMECAP hd the largest stake in the online retail company as of June 30.
See also
Joel Greenblatt (Trades, Portfolio) searches for companies that have “value with a catalyst” using a magic formula based on earnings yield and Greenblatt return on capital. Among retail companies, Gap ranks No. 13 on the list, and eBay ranks No. 22. Greenblatt’s earnings yield is simply the inverse of the EV/EBIT ratio discussed above.
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Disclosure: The author has no position in any stock discussed in this article.
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